Washington’s attempts to push inflation to the back burner is a manipulative move to stop monetary tightening. The priority now is a return to massive liquidity injections to prevent recession and systemic problems in the trans-Atlantic financial services industry.

The outcome of that policy change will be a delayed, deeper and long-lasting recession, with a further weakening of financial institutions as lending and asset values continue to decline.

With a U.S. election in November 2024, a recession and a financial crisis are unacceptable events over the next year and a half. The assumption here is that a high inflation can be tolerated, but that embarrassing runs on the banks must be avoided at any cost.

That, of course, will sow the seeds of a weak economy and a crisis prone financial system the next administration will have to deal with.

Meanwhile, the soundness of the U.S. banking system will remain as a particularly challenging policy issue.

The Fed’s flawed bank supervision

The U.S. Federal Reserve (the Fed) has failed that test, although it knew that raising the policy interest rate from 0% to nearly 5% over the last twelve months was putting a huge stress on its banking system. A sudden bankruptcy of The Silicon Valley Bank (SVP) showed the Fed’s seriously flawed system of bank supervision.

To stem the tide, the panic-stricken Fed then reversed its liquidity withdrawals by creating a huge stand by -- emergency bailout – pool of money supply.  

Paradoxically, though, that crisis-driven policy easing ended up with a debilitating credit crunch as a result of a stepped-up bank supervision. Lending is now falling sharply in 25 largest U.S. banks that account for 60% of all real estate, commercial and industrial loans.

That, obviously, has significantly raised the odds of an accelerating growth recession.

Washington, however, will not allow a recession in the runup to an election year.

We shall, therefore, see a roller-coaster monetary policy in a quick return to plentiful liquidity and a cheaper credit.

The danger then is that inflation will take off again from an annual rate of 5% (based on the personal consumption expenditure index, excluding prices of food and energy) where it had stabilized since the middle of last year.

A number of factors will drive inflation up on that new wave of rising liquidity supplies.

The demand for labor is still strong. Real disposable personal incomes have recovered markedly since the beginning of the year, after a 6% decline in 2022.

Expand food and energy supplies

Predictably, rising jobs and incomes have supported a strong rebound of household spending (70% of GDP) to an annual rate of 3% in the first two months of this year.

Now what?

It’s a safe bet that rising interest rates won’t be used to kill all that as the election contest heats up in the months ahead. High inflation will be tolerated. And there is also a silver lining: The U.S. core inflation can be controlled by expanding food and energy supplies.

Indeed, it’s odd that food prices were rising last February at an annual rate of 9.5% in a country that’s the world’s largest food exporter. The same is true of energy service prices racing ahead at 13% in the world’s largest oil and natural gas producer.

The E.U. story is much simpler. With a core inflation rate going back up to 7.5% in March, and the European Central Bank’s key interest rate at 3.5%, the monetary policy must be tightened considerably to return to the path of price stability.

That’s a tough issue because the E.U. economy seems to have entered a recession in the fourth quarter, after a strong slowdown in the course of last year. Industrial production was following the same pattern at the beginning of this year, with accelerating declines in Germany, France and Spain.

And unlike in the case of the U.S., the E.U. has no food and energy resources of its own. Unprocessed food prices are rising at annual rates of 15%, and energy and food supplies are heavily compromised by the Ukraine war.

Pressures of forthcoming U.S. presidential elections, and fears of destabilizing the financial system, have put an end to the current cycle of Fed’s monetary tightening.

Washington will try to avoid a recession by tolerating the core inflation rate around 5%. That could be possible by increasing food and energy supplies. An inevitable recession and a return to price stability will be left to the next U.S. administration.