So if the conflict and sanctions continue, how long could the Fed keep this line of fighting inflation as a priority, whatever the cost? The analysis by Alessandro Fugnoli, chief strategist of the Kairos funds When do wars end? Usually when one of the contenders clearly prevails over the other and is therefore able to dictate the conditions for peace. If neither contender is able to prevail over the other, the war ends by exhaustion of the ability to fight on both sides, i.e. when there are no more soldiers, weapons and ammunition because the conflict has collapsed the demographics and the economy of the contenders and induced public opinion to ask for peace instead of victory. In Ukraine there is still no clear prevalence of one side over the other and this, as often happens in these cases, leads the contenders to raise the level of the conflict rather than lower it. So far the political direction of the war has resisted the temptation to resort to general mobilization, use more lethal weapons and widen the conflict to include allies directly, but escalation remains the line of least resistance. On the other hand, the parties to the conflict still do not seem to have weakened enough to pave the way for diplomatic compromise. Leaving the military aspects of the question to the experts, we see in fact that on the economic level the damage inflicted on the adversaries so far is more limited than what the contenders initially imagined. Russia has avoided the collapse of the ruble and maintains a strong current account surplus. Loads of coal and oil, with more tortuous and expensive routes, still manage to be exported. Gas continues to move from Siberia to Europe. Inflation is rising, of course, but not much more than in the rest of the world. As for the West, if Russia was counting on panic in Western markets and an abrupt halt in the global growth cycle, the balance sheet is disappointing for her. The stock markets, after the initial fear, have regained a certain composure, while the estimates of GDP for 2022, although corrected to the downside, are still largely positive in America. Europe, for its part, is preparing for a phase of great uncertainty, but the delayed positive effect of the fiscal and monetary policies of the two-year pandemic means that the base scenario is still one of growth. The raw materials, for their part, are also less turbulent than one might have thought. After a period of high volatility, they stabilized. The market balances its potential scarcity with the slowdown in demand that will follow the slowdown in growth. The effect is a decrease in volatility. The fact that none of the contenders has gone to the ground and so far got away with bruises and bruises, however, means that the willingness to fight has not diminished and that the idea that with an extra effort we can win will continue to prevail. The line of least resistance remains that of more sanctions, more weapons, more military coordination, not that of more negotiations. We are still in the rising phase, that of escalation. That for the moment we are fighting with one hand is also shown by the clear divergence that is looming between fiscal and monetary policies. Normally, in times of war, the two policies are oriented in the same direction. The state finances the deficit conflict and the central bank monetizes it, creating the inflation tax that affects assets and incomes. We have done this with Covid, which we treated as a war and which, like any conflict, leaves us a legacy of inflation. This choice was not very prudent because a pandemic leaves the productive apparatus intact and produces only temporary lockdowns, while a war causes irreversible structural damage. The result is that now, while fiscal policy begins to deal with the war while remaining in an expansionary perspective, monetary policy, where it can, is dedicated to containing inflation. Governments go one way and central banks go the other, as is correct in peacetime. (Nor is it always correct, as evidenced by the Fed's useless and harmful attempt in 2018 to offset the tax cuts decided by Congress with higher rates). So if the conflict and sanctions continue, how long could the Fed keep this line of fighting inflation as a priority, whatever the cost? Have you ever seen, in times of war, a central bank provoke a recession to keep inflation down? Let us not forget that governments' appetite for spending will continue to grow. To the heavy costs of the energy transition will now be added those for rearmament and consumer subsidies of energy and raw materials. And here we are talking about much more structural and permanent costs than those of a lockdown of a few weeks. The Fed will therefore only raise rates as long as the US economy and labor market remain overheated and as long as the stock markets remain at particularly high levels. However, it is difficult to believe that it will get to the point of causing a recession, even if this is what the market thinks with the rate curve tending to inversion. Paradoxically, the loud announcement of Quantitative tightening, which apparently signals an additional degree of severity, goes in the opposite direction. The more Qt you do, the less you have to raise rates. And if the Qt calms the exuberance of the bags, all the better. It does less damage to cool the economy by calming the stock market than by aggressive rate hikes that would seriously weaken it. With the Qt, the Fed drains excess liquidity which at this moment has no function other than to support the financial markets. Furthermore, in order to drain this liquidity, the Fed will mainly get rid of long bonds, in order to keep the yield curve smooth and not inverted. If this is correct, the Fed will try to stop inflation growth and bring it down to less worrying levels, but it will stop before (as it almost always does) the completion of its rate hike program. Inflation will therefore remain, at least endemic. It is possible, as many say, that the raw materials have reached their maximum level. This does not mean, however, that they have much room to weaken, at least as long as the world grows and the sanctions remain in place. Placing them in portfolios alongside equities will remain a stabilizing factor for some time.
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