U.S. Comes Out Ahead As Central Banks Tighten The Monetary Policy Screws

Whatever dissonance there may have been in the past, U.S. Federal Reserve policymakers are certainly singing from the same song sheet now.

Fed Chairman Jerome Powell, Vice Chair Lael Brainard, and a slew of other members of the Federal Open Market Committee (FOMC) last week fanned out to talk about their commitment to bringing down inflation.

Investors have heard them and now are virtually certain that the policy-setting FOMC will proceed with a 75 basis point (bp) hike when it meets next week.

At the same time, markets are coming to believe the Fed’s actions may work.

The New York Fed’s August Survey of Consumer Expectations, released on Monday, showed that households have scaled back their expectations for inflation. They now see inflation at 5.7% a year from now, down from the 6.2% they saw in July. Three years from now, they expect it to be only 2.8%, and in five years only 2%—both down significantly from the survey for July.

They could be wrong, but inflation expectations often are self-fulfilling prophecies. If people expect inflation to decline, they will tend to moderate wage demands. They will also tend not to postpone large purchases, which won’t ease prices but will help avert a full-blown recession.

The anecdotal evidence from the Fed’s Beige Book, released last week, suggests that wage increases have slowed down as worker expectations for wage increases appear to have eased. Most tellingly, a decrease in demand—which is exactly what interest rate hikes are designed to do—was also in evidence in the reports from the Fed regional banks.

The consumer price index for August, due out today, is expected to show a decline in headline inflation as gasoline prices fall, but the core inflation rate excluding food and energy is likely to rise.

Brainard’s speech last week, while generally hawkish in tone, did note “at some point in the tightening cycle, the risks will become more two-sided,” suggesting that policymakers are certainly aware they could dampen demand too much. She quickly added that it is “important not to pull back too soon.”

Chicago Fed chief Charles Evans said he is keeping an open mind about the rate increase next week—whether it will be 50 or 75 bp. But Evans, who leans dovish, also said the strength of the dollar proves that global investors still think the Fed is credible in its fight against inflation.

Higher interest rates attract investors shopping for yield, but it is clear that the U.S. economy is showing itself resilient and the country remains shielded from much of the turmoil besetting the rest of the world, drawing investors into a safe haven.

Europe is appearing a lot less safe. Russia has halted natural gas deliveries through a Baltic pipeline, threatening a recession in Germany if businesses are forced to cut back on energy use.

The European Central Bank (ECB) felt compelled to raise its policy rate by 75 bp last week, one of the biggest hikes in its short history. For one thing, the ECB needs to keep pace with the Fed to avoid further downward pressure on the EU’s joint currency, the euro, which has already dipped below parity at times. A decline in the currency adds to inflation as imports cost more (while the reverse is helping the U.S. curb inflation).

The German defense minister made a major policy speech on Monday declaring that Berlin now aims to become Europe’s leading military power, fulfilling its destiny as the biggest economy on the continent. Germany now seems ready to leave the past behind, but it remains to be seen how other Europeans react.

The national election in Sweden registered a sharp rightward shift as the Sweden Democrats, a party previously considered marginal because of its roots in neo-Nazism, became the largest party on the center-right and stands to exert considerable influence if the center-left government loses power (final results are due later this week).

This comes as Italy faces the prospect of a rightwing prime minister at the head of a party that traces its roots to fascism, the Brothers of Italy led by Giorgia Meloni, when voters go to the urns on September 25.

The decline in the pound sterling probably owes more to Britain’s own inflation and recession forecasts and the accession of a new prime minister, but the death of Queen Elizabeth II, who was the country’s longest-reigning monarch, did not help bolster confidence.

The Bank of England postponed its monetary policy announcement for a week after the queen’s death, but it is widely expected to raise the rate by 50 bp to 2.25% on September 22.