“The Fed is about five rate hikes late”

“The Fed is off the table with a rate hike of half a percentage point,” says the former head of the New York Fed. “The US Federal Reserve will not want to put additional stress on the markets.” Before the war, some leading monetary policymakers in the US had called for a hike of half a percentage point in the spring in order to make faster progress in the fight against rising prices. Now, however, most market participants are convinced that the Fed will initiate the interest rate turnaround with a quarter percentage point at its next meeting in mid-March. Fed Chair Jerome Powell reiterated in a hearing before the US Congress on Wednesday that this would be his preferred strategy.

Otherwise, however, the US Federal Reserve must stay on course, emphasizes Dudley: “The Fed is probably four to five interest rate steps behind where it should be today”, although the ex-central banker is also talking about quarters of a percentage point here. He expects six rate hikes this year and “maybe three more” in 2023; the US interest rate is currently zero.

Dudley assumes that many causes of inflation, such as supply shortages, will actually lose their impact at some point. But he emphasizes: “The Fed must now be very careful that inflation does not become a sure-fire success.”

Fed Chair Jerome Powell left many options open at a hearing before the US Congress on Wednesday. It was “probably appropriate” to raise interest rates in March. But the effects of the Ukraine war “are extremely unclear,” he said. Therefore, the Fed must be “ready to react quickly”.

A heated debate has broken out about the future course of the world’s most important central bank. The Fed is in an extremely difficult situation, emphasized capital market expert Mohamed El-Erian, who advises Allianz, among others. Instead of orchestrating a so-called “soft landing” for the economy with rate hikes, Fed Chair Jerome Powell now has two bad choices: tolerate higher prices or fight inflation and risk potentially pushing the economy into a recession send. The fact that the Fed did not raise interest rates last year is “a historic mistake”.

>> Read here how the Ukraine war fuels the risk of inflation – “a five before the decimal point is becoming more likely”

Leading monetary politicians themselves have recently shown themselves to be extremely concerned about the war in Ukraine. “Rising energy prices will change a lot, as will the fact that goods and people can no longer move easily across Europe, that will change a lot,” said Raphael Bostic, head of the regional Fed in Atlanta. The implications for supply chains and the consequences for the economy cannot yet be precisely foreseen. “There are many things we need to find an answer to.”

According to Dudley, the ECB has lagged behind less than the Fed. He lists the differences: “In Europe, inflation is lower than in the US, inflation expectations are better anchored, and the labor market hasn’t gotten so hot.” In addition, the economic risks for Europe from the Russian crisis are much higher than for the US. This means that the risk of stagflation, a combination of a weak economy and sharply rising prices, is greater here than in the USA.

The euro will remain under pressure

Dudley suspects the euro will remain under pressure against the dollar. As long as the weakness of the common currency does not become more dramatic, the ECB will not react to it, he suspects. A weak euro can drive up inflation even further through higher import prices. In summary, this means that the USA must clearly concentrate on fighting inflation, the ECB can give a little more room to worry about the economy.

As a result of the turmoil of war, there were occasional liquidity bottlenecks on the foreign exchange market. However, Dudley refers to the Fed’s so-called swap lines in relation to other major central banks, including the ECB. “They make sure that there won’t be any major problems,” he believes.

These lines allow other central banks to exchange their currency for dollars at any time, so that they can supply domestic banks with it. During the corona crisis, the Fed temporarily bought US government bonds not for monetary policy reasons, but to keep the market functioning. Such a situation is not foreseeable now, says Dudley.

Swiss sanctions as a novelty

The American is visibly impressed by the strong reaction of the Europeans towards Russia. He mentions in particular that Switzerland has joined the sanctions: “This is a complete novelty, the country has remained neutral in two world wars.” He points out that there can now be many scenarios for the further course of the crisis, from a rapid ebb to a protracted war to a severe escalation. Because of this, Dudley believes it is impossible to provide more accurate estimates of the impact on financial markets.

Overall, however, regardless of the Russian crisis, he tends to believe that the world will not return to the pre-coronavirus state of low growth, low inflation and low yields. He believes that the so-called real equilibrium interest rate is higher today than it was before Corona. This means the interest calculated in real terms – i.e. after deducting inflation – at which the economy can be fully utilized without generating inflation.

This key figure can hardly be measured directly, but it plays an important role in monetary policy: the higher central bankers value it, the higher they have to raise their interest rates in order to absorb inflationary tendencies.

In this context, Dudley refers to the high investment requirements, for example to implement climate targets, which are driving up real returns. Increasing productivity also has a similar effect. For a long time there was very weak growth in productivity worldwide, but that too could change, for example through the greater use of artificial intelligence.

Dudley’s forecast of rising investment is also supported by a new development in Europe, particularly in Germany: a determination to significantly strengthen the military.

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