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US’ inflation fight: What lies ahead?

IFM_Economist Michael Parkin
Inflation has been there in the United States and it has been at its highest since 2021

In September 2022, a World Bank study report stated that if the central banks around the world keep on continuing to hike interest rates together, then the global economy will head towards a recession.

It came against the backdrop of the United States Federal Reserve aggressively tightening its monetary policy six times in 2022 alone. The domestic inflation crossed the 8% mark, before cooling down to 7.7% in November.

Not only the US, central banks from Argentina, India, the Philippines, Brazil, Indonesia, South Africa, UAE, Sweden, Switzerland, Saudi Arabia, Britain, and Norway too have been following similar steps recently.

While fed rate hikes have strengthened the dollar, the impact hasn’t been a kind one. Since 40% of global transactions are done in dollar, African, Latin American, and Southeast Asian countries are spending more on imports and debt payments.

Emerging markets are facing the heat as well, as investors are flocking back to the US markets, with expectations of getting better returns, amid a strong dollar. Euro is the only currency maintaining some parity with the dollar till now.

Understanding Rationale Of Fed Interest Rate Hikes
Monetary policy adjustments from the Federal Reserve cater to two conditions set by the United States Congress, keeping domestic consumer prices stable and bringing down the unemployment ratio.

So, they raise interest rates in case the inflation rate goes up too high. If it’s a high joblessness kind of scenario, they simply cut the policy rates. Other factors which the central bank keeps in mind, while forming policies, are GDP figures, consumer and industrial behaviors, financial crises, and extraordinary situations like pandemics, war, terrorist attacks, etc.

Since the United States possesses the world’s largest economy, its monetary policy changes affect global markets as well, especially the small, emerging, and developing ones.

Post-2008, while the fed rates were mostly eased to aid economic recovery, they were kept like that till 2014, in order to boost investments and consumer spending. After 2015, fed rate hikes became prominent again. And every time, policy rates were raised, the dollar got stronger, affecting credit markets, commodities, stocks, and bonds.

Another important factor to look at here is the US Treasury Bond values, which are directly connected with the monetary policy changes. As per the movement of bond rates/Treasury yield curves, interest rates within US and global markets get set. If the interest rates go up, investors put their money in the US market, putting pressure on emerging and developing economies to stay attractive. If they fail, unemployment rates go up in those parts of the world.

As per Investopedia, dollar-denominated global debt currently stands at USD 9 trillion, and emerging markets have some USD 3.3 trillion in that. For example, countries like Turkey, Brazil, and South Africa have trade deficits, and they finance their Current Account Deficits (CAD) by building up dollar-denominated debt. With a stronger dollar, the exchange rate between these nations and the US widens, leading to the ballooning of debts.

With global credit markets following US Treasury Bonds, an increasing interest rate means a hike in credit costs as well. From bank loans to mortgages, everything gets expensive, affecting consumer behavior adversely.

As mentioned in the article already, 40% of global trade happens through dollars. A stronger dollar means oil, gold, and cotton getting expensive, hurting the economies which have huge reserves of natural resources and rely on the commodity. With the value of their principal industry products declining, their available credits shrink.

However, growth in interest rates boosts the US demand for global products, aiding foreign trade and corporate profits.

Decoding 2022 Scenario
As the US economy was recovering from the aftershocks of the COVID pandemic, the Fed continued to hold the funds’ rate at around zero till the first quarter of 2022. It was also buying billions of dollars of bonds to boost the economy.

All these were happening despite the Consumer Price Index (CPI) steadily rising since 2021. It reached its record high of 8.2%, before cooling down too. So, yes, inflation has been there in the United States and it has been at its highest since 2021.

Also worth mentioning is Joe Biden’s USD 2.5 trillion stimulus program, which succeeded his predecessor Donald Trump’s USD 900 billion initiatives to deal with COVID fallouts. Both programmes have driven the upward growth of CPI indexes.

Now, as the Fed stepped in, they went for an aggressive series of rate hikes, coinciding with the global supply chain disruption due to the Russia-Ukraine war, thereby contributing more to the pre-recession build-up. Once the Fed decided it was time to do something about inflation, it moved forcefully and raised the fed funds rate by three percentage points in about six months.

The latest hike has been by 75 basis points, taking the interest rate to 3.75-4.0%. This is the highest one since the 2008 financial crisis, affecting sectors like mortgage, pension, and student loans, amid volatile job and manufacturing markets.

Can Rate Cut Be An Option?
Although the Fed officials have hinted about things possibly improving in 2023, the latest World Bank warning means the protectionist approach from the Joe Biden government needs a relook.

Professor Michael Parkin, member of the University of Western Ontario’s Economics Department, during an interaction with International Finance, said, “The US Federal Reserve interest rate increases of 2022 look too small compared with those of the 1970s that successfully lowered inflation. Over the six months from February to August 1973, the federal funds rate rose from 6% to 10.5%, and over the seven months from August 1979 to April 1980, it almost doubled from 11% to 19%.”

Talking about the Fed’s Monetary Policy stance, professor Michael Parkin remarked, “The tightening of 2022 looks small in two dimensions. First, the overall increase is smaller at 3.75 percentage points compared to 4.5 and 8 percentage points. Second, the level is a long way below those of the 1970s at 3.75% compared to 10.4 and 19.4%.”

Can Fed’s Latest Steps Be Enough To Conquer Ongoing Bout Of Inflation?
“No one knows the answer to this question. But we can get some clues to the answer by looking at the outcomes of the earlier monetary tightening in the 1970s. In February 1973, when Fed Chairman Arthur Burns started tightening, the inflation rate was 3.9% and the federal funds rate was 6.6%. Over the next six months, inflation climbed to 7.4% and the funds rate rose to 10.5%,” professor Michael Parkin added, while giving a case study of a similar situation in the 1970s.

“Despite the rising interest rate, inflation soared and by 1974 end, it had reached 12.2%. After raising the federal funds rate again to 13% in mid-1974, inflation fell to 5% but not until the end of 1976. On the road to lower inflation, the unemployment rate increased to peak at 9% in May 1975,” he said.

Drawing a parallel between the situation then and now, professor Michael Parkin remarked, “If the time lags in the 1970s repeat in the 2020s, we can expect it to take many months before inflation falls. And through the period of falling inflation, we can expect the unemployment rate to keep rising. While there are many differences between then and now, there is one striking difference that may turn out to be crucial. In the 1970s, when interest rate increases eventually lowered inflation, the interest rate exceeded the inflation rate. In 2022, the gap is reversed.”

Professor Michael Parkin also believes that if history repeats this time around, inflation will not fall until the interest rate is raised to a level that exceeds the inflation rate.

So given his prediction, the road ahead of the fed is a tough one. Not only the US, but the same situation also applies to other central banks across the world as well. Recession is looming large and despite multiple warnings from the World Bank, the phenomenon of rate hikes will continue.

However, with the latest US figures suggesting the cooling down of inflation, all the other central banks will be hoping for things to improve in the coming months so that monetary policy easing from the Fed lessens the pressure on the global economy.

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