The last time that the American dollar, US bonds and stock markets recorded a simultaneous sell off over multiple days was nearly half a century ago – in 1977-78. This would be particularly consequential for the man at the helm of the US Federal Reserve, and person entrusted with the twin mandates of maintaining full employment and price stability in the American economy – Jerome Powell.
So, when Fed chair Powell rose to speak at an event hosted by the Economic Club of Chicago Wednesday, there was palpable anticipation. Referring to the trade policies pursued by the Donald Trump administration, Powell said the steps taken by the Trump administration “will create challenges” for the central bank to meet its job and inflation mandates this year. “These are very fundamental policy changes. There isn’t a modern experience of how to think about this”.
Powell went on to indicate that the tariffs rolled out by President Trump were larger than even the highest estimates prepared by the US Fed ahead of time. “The tariffs are larger than forecasters had expected, certainly larger than we expected, even in our upside case,” Powell said in response to a question at the event. And those tariffs are only moving up for China with every passing day, and there is no certainty where it’ll end up for other countries after a 90-day pause.
“The effects of that are likely to move us away from our goals, so unemployment is likely to go up as the economy slows in all likelihood, and inflation is likely to go up as tariffs find their way” into the economy, Powell said. He added this will likely play out over the course of the year.
After Jerome Powell’s warning on tariffs, Trump posted on Truth Social that the Fed chair’s “termination cannot come fast enough!”
Market Movement Contradictions
Over the last couple of weeks, a very unusual pattern has been visible in financial market developments in the US. Generally, during phases of uncertainty, there is a higher demand for safe assets, and that tends to push down US Treasury yields (which means lower interest rates, higher bond prices). Over the last fortnight though, US Treasury yields went up. And when US Treasury yields go up, generally that leads to capital inflows into America, which, in turn, tends to boost the US dollar. But, strangely, the dollar declined while US Treasury yields rose, essentially suggesting, as former Treasury Secretary and Fed Chair Janet Yellen said on CNBC, that investors are beginning to shun dollar based assets. That calls into question the safety of what has been the bedrock of the global financial system – American treasuries. “A pattern suggestive of a loss of confidence in US economic policy and the safety of bedrock financial assets is really very worrisome,” Yellen said.
Large-scale selloffs of American bonds could pose a problem for the world’s biggest economy, making it more expensive for it to raise the money to finance its budget gap. If the American government cannot sell its debt, it is then unable to pay for things such as social security or flagship programmes such as Medicaid. For the first time in 24 months, investors had started to demand a bigger premium to hold junk-rated American debt over European equivalent, reflecting fears of a slowdown in the world’s largest economy.
With the odds of an America-led global recession going up with every passing day of policy twists by the US, it is bad news for the global economy.
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Surging Inflation Expectations
The big concern for Powell and team is that long term inflation expectations in the US are really skyrocketing. That accompanied by a growth slowdown, high unemployment, negative earnings growth, then going forward, treasuries will still be the safe haven asset. But the long term inflation expectations and inflationary impulse through random tariff policies and de-globalisation is a big factor that the Fed will have to keep in mind.
Higher tariffs and the trade war would most certainly lead to higher inflation in the US and that has set off opposition at home, including within sections of the Republican Party. This, combined with runaway deficits and a possible dilution of institutional autonomy, could lead to foreigners beginning to rethink whether they should lend unlimited money to the US Treasury — which has been a given thus far — analysts say. That could mark the beginning of the end of a big advantage Washington DC has had so far – the advantage of having the global reserve currency and the ability to continuously live beyond its means.
Experts believe that the full scale of the US Fed’s rate cutting cycle may now be at risk. Fed Chair Powell pretty much confirmed this on Wednesday. While Trump’s promised tax cuts later this year and tariff barriers could end up stimulating the US economy, at least in the short term, analysts predict they would eventually stoke inflation — and likely force the Fed to end its rate-cutting cycle sooner. Powell has said that high inflation is here to stay, which could indicate an early end to the rate cutting cycle.
That could have a bearing on the rate cutting cycles in other countries, including for India.