Dr. Powell & Mr. Volcker

Is the Fed Chairman, who announced a radical transformation of the central bank’s missions in the summer of 2020 aimed at prioritising the objective of full employment over inflation control, becoming the Paul Volcker of the 21st century, the one who will wage a merciless battle against inflation, as in the early 1980s? Each of his speeches seems to confirm a clear hardening of the Fed’s positions. He clearly assumes the possibility of 50bp rate hikes, perhaps as early as the next meeting in May. The market is now anticipating almost the equivalent of eight 25bp rate hikes in the last six meetings this year, with one 50bp hike in May or June and maybe another in September.

Such a shock treatment would have a very negative impact on the growth of the US economy in a context already marked by the consequences of the war in Ukraine. The 10-year rate has risen to over 2.3% and the spread between the 2 and 10-year rates has narrowed to 15bp. An inversion of the yield curve and in particular a negative 10y-2y spread has historically been a reliable indicator of a coming recession. 

To be fair to Jerome Powell, the rise in long rates yesterday had already started before his speech was made public, mainly fuelled by the very strong rebound in oil prices. The market is realising that central banks have waited too long to tighten policy and that it is by no means certain that they will be able to control inflation without causing a recession, the classic pattern that prevailed until the 1980s. 

The ECB President is due to speak today. Depending on the content of her speech, more or less hawkish, the downward turn in the EUR/USD exchange rate (below 1.10 this morning) will stop or increase.