Wall Street investors fear economic nightmare, stock market crash and inflation

Wall Street investors fear economic nightmare, stock market crash and inflation
Wall Street investors fear economic nightmare, stock market crash and inflation

Wall Street can’t get rid of a nightmare about the US economy.

The nightmare isn’t that the country goes into recession because of the Federal Reserve’s attempts to fight inflation – it’s much worse than that.

The latest night terrors came on Tuesday, when the Bureau of Labor Statistics said the consumer price index rose 0.1% from July to August and 8.3% from a year earlier – above analyst forecasts of a monthly decline of 0.1% and 8.1% annual growth.

Under the hood, things were ugly, too: As gas prices fell, grocery costs rose 13.5% over the past year — the biggest increase since 1979 — and the cost health insurance grew 24.3%, the largest increase in US history.

This disappointing report means that Wall Street’s nightmare scenario for the economy is still unfolding. In this scenario, there is no hard landing or soft landing for the economy; we’re just stuck. Inflation drops a bit from its scorching level but remains consistently higher. The Federal Reserve — for reasons ranging from a fragile labor market to government debt — cannot aggressively shake higher prices out of the system. And Americans end up with uncomfortably high interest rates on things like mortgages and credit cards. and higher prices, which continue to eat into wages and destabilize prices.

Basically, the economy sucks.

Soft, hard and neutral

The Fed’s current goal is to return the economy to a “neutral” state where growth is stable, the labor market is holding up, and inflation is high enough to help fuel growth, but not so high that we have price instability. In a healthy US economy, the Fed’s inflation target is 2% year over year.

Since the 2008 financial crisis, the Fed’s biggest problem has been that inflation is too low. He therefore kept interest rates at 0% to stimulate financial activity and growth. Then the COVID-19 pandemic hit, supply and demand went haywire, and eventually inflation spiked in the economy as it reopened.

When inflation starts to climb, central banks like the Fed raise interest rates to make it more expensive to borrow cash. This slows the flow of money through the economy and, in theory, slows price growth. But in this case, prices didn’t go up – they jumped up, and the Fed was caught on the wrong foot.

Wall Street constantly insists on the Fed for acting too late to keep up with inflation – for not raising rates fast enough. But I’m not here to speculate about past politics. In the world of financial markets, that’s how you go from polite country club conversation to something like an argument in Elon Musk’s Twitter mentions in no time.

But we can all agree that the Fed now has a serious problem on its hands. Chairman Jerome Powell and his gang have raised interest rates pretty quickly, but the Fed’s main interest rate is still just 2.5%. That’s not enough to get us out of 8% inflation, let alone bring us back to the Fed’s 2% target. This is why the Fed says that rates will continue to rise.

The difference between a hard landing and a soft landing for the economy is How? ‘Or’ What this gap is closed. In a soft landing scenario, supply catches up with demand, prices fall, and inflation numbers fall to reach interest rates without the Fed having to cause too much trouble in the labor market or push us into a recession. In a hard landing scenario, the Fed raises interest rates to keep up with inflation, which in turn slows the economy, drives up the unemployment rate, and pushes us into a recession.

But there is a third option, one in which the pain we feel subsides, but never completely disappears.

a long way to go

This is where the Wall Street nightmare scenario comes in. It’s not a hard or soft landing. It’s not a landing at all.

Earlier in the year, the price spike came mainly from categories affected by external forces, such as gasoline prices and used cars, which rose due to the invasion of Ukraine by the Russia and the pandemic, respectively. But as the months pass, these price pressures ease. Inflation is starting to come from “stickier” categories: apartment rents, health and services. This seriously increases the odds that instead of resolving on its own, inflation will stay with us for a very, very long time.

The worst case is an economy where interest rates and inflation never meet. It is a vacuum of stubbornly high inflation and higher interest rates. The Fed keeps raising rates but never does so in a way that truly tames inflation. Price growth is holding around 4% or 5%, well above the Fed’s target. Businesses are grappling with rapidly rising input and labor costs, higher borrowing costs and great uncertainty about economic growth. It’s also terrible for jobs and American households. Jason Furman, who was a White House economist during the Obama administration,

that although not its most plausible case, this nightmare scenario with inflation remaining above 4% and unemployment exceeding 6% is still on the table.

David Einhorn, the founder of hedge fund Greenlight Capital, also spoke about this doomsday scenario at the Sohn Investment Conference in June. He said at 8% inflation, the Fed would have to raise interest rates to 7% to achieve neutrality.

“The idea that a one or two percent tightening from here will beat inflation is barely believable,” he said. Einhorn argued that the Fed needed to rise more dramatically – to give the economy a massive boost like Paul Volcker did as president in the 1980s. But Einhorn added an ominous wrinkle to this scenario: that the Fed would be stopped in its tracks by what high interest rates would do to the US Treasury.

“Powell faces a problem that Volcker didn’t have,” Einhorn said. “We have $24 trillion in debt held by the public, which has increased sixfold over the past 20 years. About $7 trillion is due for renewal next year. Each 1% increase in rates adds $70 billion to the deficit, so raising rates to 4% would add $280 billion, 8% would be $560 billion, and a full Volcker – 19% – would be $1.3 trillion. . And this is only the first year.

In the face of all of this, the Fed will have to blink and stop raising rates, leaving us with persistently high inflation and interest rates that are dragging the economy down. And Einhorn is not alone in thinking that Fed policy is constrained in this way. In August, Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed published a paper claiming that a lack of constraint in fiscal spending also psychologically pushes inflation higher. Since no one in Washington can stop spending, the market does not believe that economic conditions will really tighten. If the market wants to believe we are serious about inflation, they say, we need to tighten our fiscal policies.

If Einhorn, Bianchi and Melosi are correct, we could be in the economic limbo of stubbornly high inflation and higher interest rates for some time.

None of these scenarios – good, bad or ugly – are certain. The Fed has been raising interest rates for only a few months, and we don’t have enough inflation data to know if its policy alone will be enough to get us back to neutral. JPMorgan analysts believe a soft landing is still within reach. The United States is still creating jobs at a healthy pace and consumption is still strong. China’s economic slowdown is pushing commodity prices down. One can dare to hope that the Ukrainians will continue to push Russian forces out of their territory, which would also help to stabilize food prices. All is not lost.

Einhorn acknowledged that his theory could be wrong, but the Fed could also be wrong. It is possible that the Fed’s inability to raise rates earlier in the pandemic will lead it to raise rates significantly next year, pushing our economy into a recession. Or maybe everything will work out without too much economic difficulty.

But there is also the terrible and miserable third way in which we cannot defeat inflation at all. We must hope to avoid it at all costs.

Linette Lopez is a senior correspondent at Insider.

. investors Wall Street fear nightmare economic crash stock market a inflation

. Wall Street investors fear economic nightmare stock market crash inflation

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