Sat. Jan 22nd, 2022

The Fed has made it clear that a precondition for raising interest rates is the end of its quantitative easing program. If it was previously scheduled to end in the middle of next year, it now looks like it could happen in the first quarter, paving the way for what Powell has termed “lifting off” or the first rise in federal the funds rate since 2018.

Powell’s change of tone had an immediate impact on the financial markets, which were still trying to control the emergence of the Omicron strain of coronavirus.

After withdrawing the word temporarily, the world will wait anxiously for more details on how it plans to respond to inflation, which is apparently anchored at uncomfortably high levels amid the unpredictable disturbances of the continuing pandemic.

The U.S. stock market, which had returned on Monday after their Black Friday sale, fell nearly two percent. It has now dropped nearly three percent within a week.

Powell’s sharp change in language and thinking echoes what happened in early 2019, when the tightening of monetary policy that the Fed had begun in October 2018 triggered a sharp downturn in the markets, which led to the “Powell hub” and a sudden change in the Fed’s plans.

The potential for a tantrum is greater this time around given how the stock markets have been trading since March last year. The market has risen almost 100 percent from its low point in March 2020, when the seriousness of the threat from the pandemic first became apparent.

Wall Street fell sharply after Powell's testimony.

Wall Street fell sharply after Powell’s testimony.Credit:AP

Warren Buffett has a crude goal of assessing whether markets are undervalued or overvalued. With long-term corporate profitability strongly correlated with long-term economic growth, he has argued that the value of the stock market should reflect the size and growth of the economy.

The US stock market is now valued at more than 205 percent of US GDP. At its nadir in March last year, it was about 120 percent of GDP. The long-term average is below 90 per cent. The market trades on extremely stretched valuations and is unusually vulnerable to bad news.

Currently, there are two sets of threatening developments.

Higher interest rates will affect the valuation of the highest rated stocks because the discount rate used to calculate the present value of their future cash flows will increase.

Markets accustomed to risk-free below-zero interest rates in real terms are at risk when interest rates rise, although bond markets at least currently appear to be pricing only two rises of 25 basis points next year.

The extent to which the Fed and its peers elsewhere will raise interest rates is likely to be limited by the large increases in government and household debt levels during the pandemic. Relatively small interest rate hikes can have significant negative consequences in the real economies, which may help to limit the extent of the threat to the financial markets.

The pandemic, which had been seen as a declining influence before Omicron emerged, remains a threat due to doubts about the effectiveness of existing vaccines in dealing with the new strain and the demonstration that Omicron has given of the potential for new and more harmful mutations to occur.

The impact of the pandemic on global supply chains and global economic activity may be too deep and prolonged due to the new border closures and other measures that countries are now taking and creating the perverse result of continued high inflation rates as economic activity declines.

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Governments and their central government do not have the capacity to respond to new outbreaks or declining growth that they had at the beginning of the pandemic.

How Powell responds to the dual challenges of inflation and the pandemic has real implications for the other major economies due to the Fed’s oversized role in the global economy and financial system.

After withdrawing the word temporarily, the world will wait anxiously for more details on how it plans to respond to inflation, which is apparently anchored at uncomfortably high levels amid the unpredictable disturbances of the continuing pandemic.

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