Will the Fed win the war on inflation? It’s complicated

EARLIER hopes that annual inflation in the United States may be falling were dashed when figures published in September showed that excluding the volatile food and energy categories, core inflation clocked in at 4.9 per cent in August, up from 4.7 per cent in July.

That explained why the US Federal Reserve decided to raise interest rates by 75 basis points for the third consecutive time – an unprecedented move since the central bank began explicitly targeting the federal funds rate in the late 1980s. The Fed continues to try to tame four-decade highs in inflation, now running at more than 8 per cent.

Indeed, contrary to the wishful thinking of some investors that the spell of inflation may be over and that the Fed would start easing on its monetary fight, the central bank’s leaders have made it clear in recent days that they intend to raise rates higher and higher, then maintain them until there is “clear and convincing” evidence, as chairman Jerome Powell put it, that inflation is cooling.

As Powell and his colleagues have insisted, turmoil in the financial markets and fears of recession – or for that matter, the devastating effects that the Fed’s hikes would have on other economies – will not change that sentiment.

“Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target,” said Powell on Sep 23 in Washington.

And at a conference in New York last Friday, Fed governor Lael Brainard stressed that it would take time for the full effect of higher interest rates to work through different sectors and bring inflation down, and insisted that the Fed was committed to not pulling back prematurely.

To put it bluntly, the Fed seems determined to crush rising prices and bring inflation down to its target of 2 per cent, with experts expecting another 100 to 150 basis point rate increase this year, notwithstanding the costs for the US and global economies.

The effects of the Fed’s policies have already begun to sink in, at home and around the world. American stocks have fallen for three consecutive quarters, bond prices are dropping, and there are early signs that mortgage rates are rising and home prices are falling. The latter amounts to good news for consumers who want to purchase a house, while hurting owners who want to sell their home, in just another example of the complex challenges facing the Fed in its fight.

Perhaps the major problem for the Fed has to do with the huge fiscal stimulus programmes passed under President Joe Biden and his Republican predecessor in response to Covid-19.

US consumers, firms and local governments accumulated a lot of cash while Americans were locked down at home and businesses closed down during the pandemic. They are now spending that cash – which becomes clear when you notice the construction taking place in large urban centres, or spend some time in US air terminals and shopping malls.

Try to make a reservation in a restaurant, book a flight or get a room in a hotel, and you would have to conclude that the American economy is booming – a sentiment that runs contrary to the Fed’s mission of getting consumers to stop spending so much, as said spending is boosting demand, raising corporate profits, and increasing inflation.

Similarly, a historically low unemployment rate of 3.7 per cent has helped create a tight labour market, with now around two vacancies for every unemployed American. This major shortage of workers is putting upward pressure on wages, which are up 7 per cent compared to last year – which also means that these happily employed workers now have more earnings to spend.

At the same time, unlike in Europe where they have remained high – especially given the war in Ukraine – energy prices have started to fall in the US, while its energy exports have risen. In fact, higher oil and gas prices benefit the American energy industry.

The reality of an overheated American economy explains why the task facing the US central bank seems at times like Mission Impossible, leaving the Fed no choice but to continue raising interest rates until inflation reaches its target, while hoping that this restrictive monetary policy doesn’t end with a painful economic recession.

Yet what is already becoming clear is that the Fed’s aggressive monetary moves are creating global economic pain, as other central banks try to keep up with their American counterpart.

More specifically, US monetary tightening is closely associated with a stronger US dollar, pushing the greenback at least 7 per cent higher compared to some other major currencies. That has led to a so-called “reverse currency war”, with other central banks trying to boost their currencies and fight inflation through interest rate increases.

Yet there are no indications that the Fed will alleviate the pressure on other countries to raise rates by halting its own hiking cycle. If anything, a stronger dollar helps US shoppers by keeping a lid on import prices and hence putting downward pressure on inflation. US companies that sell abroad also see their profits get squeezed.

But a strong US dollar can put a financial squeeze across the developing world. Many companies and governments in such emerging markets borrow money in US-dollar terms and have to repay these debts accordingly, even as their own currencies buy fewer dollars by the day. This can create a lot of economic pain in these countries – whose diplomatic support Washington needs in its geo-strategic fight with Russia.