The central bank is walking a fine line, as raising rates too fast and too hard could trigger a recession amid signs of a broadening economic slowdown.
On Wednesday, the U.S. Federal Reserve imposed another 75-basis-point rate hike, the largest back-to-back rate increase in decades, in a bid to tamp down rampant inflation. The latest move, which came as inflation remains four-decade high, shows the urgency for the central bank to get surging inflation under control.
The Fed has already hiked interest rates by 225 basis points since March this year, and is set to continue its aggressive path, which raises risks for a possible recession and brings negative effects to emerging markets.
The central bank is walking a fine line, as raising rates too fast and too hard could trigger a recession amid signs of a broadening economic slowdown. The increase is "excessive, especially at a time when the U.S. appears to be on the cusp of recession," and as U.S. equity markets have suffered the worst first-half-of-year losses since WWII, said Desmond Lachman, senior fellow at the American Enterprise Institute.
"The danger now is that the Fed does too much and drives the U.S. economy into an unnecessarily hard landing," Lachman noted. Dean Baker, senior economist at the Center for Economic and Policy Research, told Xinhua Wednesday's rate hike "gets us back to a normal federal funds rate, Further big hikes would be a serious problem."
However, Fed Chair Jerome Powell said Wednesday afternoon at a press conference that "another unusually large increase could be appropriate at our next meeting." He explained that the current range of 2.25 to 2.5 percent is what the Federal Open Market Committee (FOMC) considers as neutral level -- meaning Fed's monetary policy is neither accommodative nor restrictive.
"I think the committee broadly feels, we need to get policy to a moderately restrictive level," Powell said, citing the latest quarterly FOMC projections released in June, which showed that the federal funds rate at the end of this year is 3.4 percent.
If the Fed raise the projected terminal rate of this hiking cycle to more than 4 percent, it indicates that "they may need a recession to bring down inflation," said Adam Posen, president of the Peterson Institute for International Economics.
Powell told reporters that the Fed sees "two-sided risks" as it continues its fight against inflation. "There would be the risk of doing too much and imposing more of a downturn on the economy than was necessary, but the risk of doing too little and leaving the economy with this entrenched inflation, it only raises the cost (of dealing with it later)," he said.
Headline consumer price index (CPI) has remained over 8 percent since March this year, and CPI in June surged 9.1 percent from a year ago, a stark reminder that the Fed has a long way to go to bring inflation under control.
Officials called inflation "elevated" and said the problem was due to supply chain problems, as well as high food and energy prices. Many economists and policymakers, however, said inflation was also due to the current administration's profligate spending and the Fed's slow response.
"The Fed took a gamble," Posen said. "When the ARP (American Rescue Plan) was passed by in March 2021, however, the Fed should have shifted its stance towards tightening and abandoned the 'transitory' language."
"It was clear inflation was going to come in higher, and they should have updated their forecasts. They should have been tapering quantitative easing and begun to tighten by no later than June 2021," said Posen, who had warned of higher inflation before.
The White House is attempting to redefine what a “recession” means following widespread concerns by economists that the United States’ economy could be headed into a recession due to two successive quarters of negative GDP growth.— Rebel News USA (@RebelNews_USA) July 26, 2022
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Treasury Secretary Janet Yellen also admitted that both her department and the Fed had overlooked the problem and had been too slow to act, and both could have probably used a better word than "transitory."
Skyrocketing inflation has significantly hurt U.S. President Joe Biden's approval rating, which stands at a record low of 37.7 percent, according to the Real Clear Politics' average of polls. Analysts said this is likely to impact Democrats in November's midterms, and some are predicting a nationwide Republican wave.
"If Biden can get inflation back to manageable levels, that would be a big plus for Democrats in the midterm elections," Brookings Institution Senior Fellow Darrell West said.
If the inflation is not brought under control, Democratic candidates will run against the Fed in order to deflect blame, and Republicans will also run against it, conflating the Fed with Democratic policies, pointed out Clay Ramsay, a senior research associate at the Center for International and Security Studies at the University of Maryland.
The Fed raised its benchmark interest rate by 75 basis points at June meeting, the sharpest rate hike since 1994. The Fed previously raised rates by 25 basis points in March and then by 50 basis points in May. More rate hikes are expected to come, as signaled by Fed chief. Given its important role in the global financial system, spillover effects are all but certain.
In the newly released update to its World Economic Outlook, the International Monetary Fund (IMF) said Tuesday that tighter global financial conditions could induce a surge in debt distress in emerging markets and developing economies.
"We could see at some point some of these financial tightness, some of these financial pressure starting to really bear down on some emerging market economies," IMF chief economist Pierre-Olivier Gourinchas said, adding that "so things have not been too disorderly up until now, but of course we are concerned as to whether this might continue in the future."
Higher U.S. interest rates are already causing a large outflow of capital from emerging markets in very much the same way they have done on previous occasions.
"This is causing emerging market currencies to slump and is now raising the prospect of a large wave of debt defaults in the highly indebted emerging market economies," Lachman said.
"The Fed now needs to wait to observe the impact," Brookings Institution Senior Fellow Barry Bosworth said, adding that "the economy is close to the tipping point into recession. The impact will be particularly strong on emerging markets."