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Financial Markets Plunge After 30-Year High Inflation

Although monetary authorities insist on the transitory nature of inflation, markets seem to be preparing for a rise

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Markets fell after the latest inflation report indicated that the U.S. is experiencing the steepest price growth seen in 30 years.

While the S&P500 financial index fell 0.9 % on Wednesday, the NASDAQ technology index fell 1.7 % indicating that rising inflation expectations have investors worried.

Interest rates (yields) on U.S. short-term debt bonds also rose on Wednesday, suggesting that the increase in consumer prices will lead the Federal Reserve to raise interest rates sooner than expected, as inflation, in addition to affecting Americans’ pocketbooks, also impacts the cost of government leverage.

Although the central bank has acknowledged that inflation is high, it is still attributing the increase in prices to cyclical factors such as the container crisis in China, the emergence of the Delta variant or the shortage of microchips.

inflation
Although the FED itself recognizes that inflation will be persistent, it still attributes it to cyclical factors such as the container crisis or the shortage of microchips. (Image: EFE)

The Fed decided to reduce bond purchases by $15 billion in November and another $15 billion in December, and to gradually taper purchases until completely eliminating them in July 2022. Since March 2020, the value of debt securities purchased by the Fed has doubled to $8 trillion by October.

Despite this, the central bank, after the last Federal Open Market Committee (FOMC) meeting, announced in a press release that the increase in prices is “largely reflected in factors that are expected to be transitory.”

Markets contradict the Fed

Although the monetary authorities insist on the transitory nature of inflation, the markets seem to be preparing for higher inflation in the future: retailers accumulate inventory to shield themselves, and people make compulsive purchases thinking that products are going to become more expensive, as explained by the price of used cars, which has grown by 26.4% in the last twelve months.

As explained by the former finance minister of Uruguay, Ignacio de Posadas, in a forum with El American, “Inflation has a series of economic explanations, but it is also a psychological phenomenon.” If people anticipate that there will be more inflation in the future, they will consume more in the present assuming that everything will be more expensive in the future, causing more inflation.

Raising of interest rates

Some economists, like University of Notre Dame macroeconomics professor Rüdiger Bachmann, believe it is time for the Fed to end its expansionary policy. “I think inflation is unprecedented, I think it is time for the Fed to have a more contractionary policy or reduce its expansionary stance. The tapering is a good step in a good direction. I would like to see more, I would like to see them thinking about raising interest rates,” he explains.

One of the criticisms the Fed has received is the lack of clarity in its new monetary policy. Before 2020, the Fed had a target inflation rate of 2 %; today the central bank maintains that the inflation target should average 2 %, but does not clarify what time horizon would be taken into account to estimate that average inflation.

The interest rate at which the Fed lends to commercial banks is the main mechanism the central bank has to inject or limit the money supply in the economy, as it directly influences the cost of credit that Americans or businesses assume when lending at commercial banks.

“I would like them to give guidance like this: if inflation in January remains high, we will raise rates by x %,” explains Professor Bachmann on how the Fed could make its monetary policy more transparent.

inflation
With the Biden administration’s fiscal expansion, the Fed may have to raise interest rates in 2022 to keep inflation from getting out of control. (Image: EFE)

During the pandemic, monetary policy underwent another particular change, and that is that the transmission of liquidity began to be channeled directly to households through the government, with pandemic stimulus checks, corporate payroll subsidies, among other programs that arose from the coronavirus crisis.

This second channel is far from closed, as two fiscal expansion plans await the U.S. that together could inject more than $4.7 trillion in spending into the economy: the bipartisan infrastructure plan and President Joe Biden’s social spending plan.

“I would like to see them take a more aggressive stance on monetary policy, especially if the Biden administration essentially maintains the fiscal stimulus, so on the fiscal side we would have inflationary pressure anyway. We have inflationary pressure from the supply side of the economy, so the Fed basically needs to try to turn off the pressure that it exerts before it gets out of control,” Bachmann comments on the risk of injecting liquidity into the economy on both the fiscal and monetary sides.

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