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Wednesday, May 22, 2024

The Fed Rate Hike: Alleviating inflation or invoking stagflation?

The fed funds rate has been zero-bound since March 2020 to support the economy through the pandemic. And although both monetary and fiscal perspectives bolster this decision, uncertainty still looms regarding the broader economic repercussions of the geopolitical tensions coupled with supply chain disruptions and swelling International commodity prices.

The precedented rate hike is finally at the doorstep. Last week, the Fed raised the federal funds rate – the US benchmark interest rate – by 25 basis points into the 0.25%-0.5% range. Albeit the first hike since 2018, it is hardly unexpected. The fed funds rate has been zero-bound since March 2020 to support the economy through the pandemic. And although both monetary and fiscal perspectives bolster this decision, uncertainty still looms regarding the broader economic repercussions of the geopolitical tensions coupled with supply chain disruptions and swelling International commodity prices.

While unemployment comfortably stands at 3.8%, the pandemic still lingers, and the global supply chain is still vulnerable to the impact of the pandemic and sanctions on Russia. Hence, while the inflationary pressures justify this aggressive policy stance, it could come at a cost – dampened economic growth, market stagnation, or worse – a recession.

Read more: Why is there a global price hike in the oil market?

The concerns regarding Fed

The concerns of the Fed are legitimate and already reflected across the developed economies facing similar predicaments. The Bank of England (BoE) has consistently raised interest rates from the near-zero level. Since December, the BoE has hiked interest rates thrice via back-to-back quarter-point increments – settling at a pre-covid level of 0.75% last Thursday. The reasons are almost identical – soaring inflation, bulging commodity prices due to the Russian invasion of Ukraine, and supply chain disruptions. Similar to the economic woes of Britain, the US faces a dilemma – risk a recession via aggressive monetary policy tightening or continue to lose consumer/business confidence due to inflation.

The Monetary Policy Committee (MPC) recently suggested that the BoE expects inflation to strike about 8% by the end of the second quarter of 2022. According to the Consumer Price Index (CPI), the inflation rate in the US is following a similar (but more severe) trajectory – registering at 7.9% for the 12 months through February. Expert forecasts indicate that soaring energy prices alongside accelerating global commodity prices could nudge the inflation rate into double figures this summer. Thus, the modest tightening of the monetary policy could cushion the adverse effects of an overly-heated economy. However, two questions stand at the apex of this shifting monetary directive –

Read more: Pakistan’s cheapest car company “sorry” for price hike

How aggressively should the Fed approach?

“I think the recession risk is very high,” said David Rosenberg, an economist based in Toronto. “The Fed is caught in a box of its own making because it didn’t move quickly enough on raising rates. Now it has to be seen to move aggressively.” It is patent that the rate hike – being a necessity of time – is a belated gesture when the inflationary pressure has already breached levels not seen since the 80s.

And while it is not explicit that high prices have entrenched into the consumer psyche, it is apparent that an aggressive approach amidst geopolitical turmoil could reel the economy – currently near full-employment – into the abyss of recession. Even Jerome H. Powell – the Fed Chairman – conceded during the news conference last week. In response to a reporter’s inquiry, Powell admitted that the Fed “obviously” should have started tightening the rates long before the inflation gripped the economy.

While the Fed continued to claim that inflation is mere “transitionary” in nature, the Federal Open Market Committee (FOMC) – the policy-setting body of the Federal Reserve – recently acknowledged that financial markets statistics had been projecting chronic inflation for months. In another statement last week, Powell stated: “Inflation is likely to take longer to return to our price stability goal than previously expected.” Therefore, it is clear that despite the tightening monetary policy, inflation may go on to prove as persistent as in the Volcker era. The expected inflation would likely stay well above the targeted 2% through 2023 – and maybe even 2024.

Despite the fears of stroking recessionary pressures, the reception to the Fed announcement has been fairly muted. The stock market expanded in routine, the treasury yields have stabilized, and the commodity prices have moderated. But this is the short-term impact – the long-run outlook seems trickier than initially anticipated by the Fed. That is due to multiple factors. The global oil market is flirting above the $100/ barrel mark – slipping from a decade-high $140/barrel last week.

Read more: Prime Minister takes notice of GNN program on Gas price hike

Despite an optimistic dialogue, no breakthrough in the Russo-Ukraine conflict seems on cards. Thus, prices of core Russian commodities – like copper, palladium, and wheat – are unlikely to correct any time soon. Supply chain concerns could further multiply as the worst Omicron spread forces China into a whelming lockdown. A tightening monetary policy paired with such severe supply-side impediments – not the best of the combinations. A prolonged disruption could definitely trigger a recession in the United States. However, prudence is a key that could unlock this proverbial deadlock.

This rate hike is the first of the seven expected this year

In addition, the aggressive shift in direction indicates that the Fed could soon begin reversing its Quantitative Easing (QE) program – which has burdened its books with $8.9 trillion worth of government securities. The trick is to be wary of the vacillating geopolitical and commercial pressures. The Fed has an extensive arsenal of monetary tools; it currently walks a tight rope between price stability and maximum employment.

It wouldn’t want the economy to witness the days of stimulus cheques and unemployment support. Thus, it is now a game of controlling market sentiment via soft messaging and flexible policy decisions. So far, the Fed is winning. Any haste or miscommunication would ultimately lead to a panicked economy with a recession walking hand-in-hand with inflation and low growth: Stagflation would be the ultimate fate of the US economy.

 

The writer is currently working as a writer for South Asia Magazine and a columnist for Modern Diplomacy – a European Think Tank. The views expressed in this article are the author’s own and do not necessarily reflect the editorial policy of Global Village Space.