Fed Chairman Powell is attempting a difficult balancing act: he must bring record inflation under control while avoiding stalling the economy. That might be painful.
The US Federal Reserve will hike interest rates further today. This will dampen the already weakening economy even further and risk the world’s largest economy slipping into recession. But central bankers have no choice – they must bring rampant inflation under control, which has reached its highest level in 40 years.
Inflation had picked up speed over the past few months and was 9.1 percent in June. Meanwhile, the central bankers kept saying that price increases would soon have peaked. However, that turned out to be far too optimistic.
In order to get inflation under control, the Fed said goodbye to its long-standing low interest rate policy in March and increased interest rates. Another step followed in March. In June, the Fed followed suit and raised interest rates by a whopping 0.75 percentage points. The last time there was such a big step was in 1994. The key interest rates are currently in a range of 1.5 to 1.75 percent.
The Fed is widely expected to announce another 75 basis point hike today, with inflation stubbornly rising, and interest rates to rise to a range of 2.25 to 2.5 percent. It has thus reached the so-called neutral interest rate, which means that economic activity is neither stimulated nor slowed down. This cannot be quantified exactly, but economists see it at 2.5 percent for the USA.
This means that with every further rate hike by the Fed, the probability of an economic downturn increases. Higher interest rates make loans more expensive and make saving more attractive. Companies invest less, consumers spend less money. This slows aggregate demand and tends to lower inflation.
So the Fed is in a bind: it needs to get inflation under control without stalling the economy. It won’t be easy. The US economy shrank by 1.6 percent in the first quarter over the year. On average, economists expect gross domestic product to have grown by just 0.4 percent in the second quarter. The official data will be published tomorrow Thursday. Should economic output have fallen, the USA would be in recession.
Against this backdrop, Fed Chair Jerome Powell is trying to show determination: failing to restore price stability is worse than causing a recession. The central bank sees price stability at an inflation rate of 2 percent. And she is far from that.
Powell’s rhetoric is likely to have one primary goal: to prevent a dangerous wage-price spiral. It threatens when broad sections of the population assume that high inflation is not a temporary phenomenon. The logic behind it: Employees therefore push through higher wages across the board. Companies raise prices to compensate. As a result, the general price level continues to rise – and a chain reaction occurs. In the US, the robust labor market increases this risk. Unemployment was 3.6 percent in June for the fourth straight month.
The situation is also complicated for the Fed because inflation is being fueled by factors over which it has no control: Russia’s aggressive war in Ukraine is making energy more expensive. The tough lockdowns in China are repeatedly disrupting global supply chains, causing supply bottlenecks and thus leading to higher prices. With its interest rate policy, the Fed can neither ensure smooth supply chains nor cheaper gas. It cannot affect these supply shocks, it can affect demand.
In addition, interest rate increases affect prices with a time lag – the rule of thumb is between 12 and 18 months. In the worst-case scenario, the Fed’s rate hikes will only have a full impact when the economy is already deep in recession.
There are already signs that high inflation is slowing down the economy. One example is retail giant Walmart, which is a good predictor of US consumption. Management predicted a slump in profits for the current second quarter. Compared to the previous year, it will be up to 14 percent lower. Rationale: Due to high inflation, consumers have to spend more of their money on petrol and groceries and are buying less clothing and electronics, for example. Leading companies in various industries have announced that they will slow down the pace of new hires – including the automotive group General Motors and Google’s parent company Alphabet.