How big is the impact of aggressive interest rate hikes on the U.S. economy?

Source: People's Daily Overseas Edition

On June 15, in Washington, D.C., Federal Reserve Chairman Jerome Powell attended a press conference and announced a 75 basis point rate hike. Photo by Xinhua News Agency reporter Liu Jie

In recent months, in order to curb inflation growth, the pace of interest rate hikes by the Federal Reserve has continued to accelerate, triggering market concerns. Some argue that the Fed may be fighting inflation or suppressing the demand side, which could lead to the U.S. economy "entering another recession." The International Monetary Fund (IMF) recently released a report that cut the 2022 US economic growth forecast to 2.9% from 3.7% in April forecast, arguing that the US path to avoid a recession is narrowing.

Fed Chairman Powell recently said that after the Fed's historic interest rate hike in June, the economy is "likely" to decline, and the so-called "soft landing" has become very challenging. In the Wall Street Journal's view, this comment is tantamount to a vague acknowledgment that as monetary policy tightens, the risk of downside to the US economy rises.

Hike "Walk Fast"

According to US media reports, on June 15, local time, the Federal Reserve announced a 75 basis point interest rate hike, raising the benchmark federal funds rate to a range of 1.5%-1.75%, the largest single rate hike since November 1994. Notably, this is the Fed's third rate hike this year. In March and May, the agency has raised rates by 25 and 50 basis points, respectively. The Fed expects the benchmark federal funds rate to reach 3.25 to 3.5 percent by the end of the year — which would be the highest level in the U.S. since 2008.

Recently, Fed Chairman Powell revealed that the Fed will raise interest rates by at least 50 basis points in July, and does not rule out the possibility of another sharp 75 basis points hike, in order to "firmly return the US inflation rate to the 2% target."

At present, the problem of inflation in the United States is becoming increasingly serious. According to the Wall Street Journal, the U.S. Department of Labor recently released data showing that the U.S. consumer price index rose 8.6% year-on-year in May, the highest since December 1981. Soaring energy and food prices have pushed prices up, with little indication of when this upward trend will ease, the report said.

"Since the outbreak of the new crown pneumonia epidemic, the Fed's monetary policy has undergone a huge transformation." Chen Fengying, a researcher at the Institute of World Economics of the China Institute of Contemporary International Relations, pointed out to this reporter that in 2020, in order to support the US labor market and economic recovery, the Federal Reserve once announced that it would allow the inflation rate to be "moderately" higher than 2%, and quickly implement zero interest rates and unlimited quantitative easing. In 2021, in the case of a significant rise in prices, the Fed has been slow to respond, constantly releasing "inflation temporary" signals to the market, ignoring the structural problems behind inflation. Due to the introduction of a number of economic stimulus bills in succession by the last two US governments, as well as the rise in international commodity prices caused by the outbreak of the Russian-Ukrainian conflict, coupled with the speculation of floating capital, the inflation problem in the United States continues to intensify. Under the combined effect of multiple factors, the US government is busy and ineffective, and the Fed's policy has to take a "sharp turn" and speed up interest rate hikes and balance sheet reductions in order to suppress domestic inflation as soon as possible.

"From thinking that inflation is a 'temporary problem' to acknowledging that it is the 'primary issue,' the Fed's perception and judgment of inflation has undergone an adjustment process. Overall, U.S. monetary policy is moving further in the direction of tightening. Yang Panpan, deputy director of the International Finance Research Office of the Institute of World Economics and Politics of the Chinese Academy of Social Sciences, analyzed that the Fed tried to guide market expectations through large-scale interest rate hikes to avoid high inflation from evolving into a long-term trend.

The market is worried

On June 28, local time, the World Federation of Large Enterprises released data showing that the US consumer confidence index fell further to 98.7 in June from 103.2 in May, the lowest level since February 2021, reflecting that the high level of inflation has seriously affected US consumer confidence. On the day, the U.S. stock market closed sharply lower in a massive sell-off, and investors' concerns about rising recession risks and declining corporate earnings prospects grew.

Analysts point out that the inflation problem will not be resolved quickly because of the Fed's interest rate hikes. At the same time, as monetary policy tightens, the risk to the downside of the US economy may rise. Even Powell had to admit that "this is not the outcome that the Fed wants, but it does have the possibility." He also stressed that the Fed's goal is to achieve a "soft landing" and strive to suppress inflation without causing a recession.

Bill Dudley, former president of the Federal Reserve Bank of New York, recently published an article in Bloomberg that the "benign scenario" predicted by the Fed will not appear. With tight financial conditions, constrained fiscal policy, and depleted household savings, consumer confidence will be hit hard, unemployment will rise, and a "hard landing" for the economy may be inevitable. The U.S. economy will "inevitably" fall into recession over the next 12 to 18 months.

"The U.S. government's monetary policy is now in a difficult position to ride the tiger." Chen Fengying said that one view is that inflation should be curbed by raising interest rates to avoid stagflation; Another view is that aggressive interest rate hikes will burst the economic bubble, causing unemployment to rise and consumption to fall, resulting in a recession, which is a typical manifestation of economic stagflation.

"The current round of inflation in the United States is not entirely a demand-side problem, but also a supply-side problem. The Fed has had limited success in managing inflation through tight monetary policy to curb the demand side. Chen Fengying said.

"The Fed's loose monetary policy in the early stage, the epidemic and geopolitical conflicts and other factors leading to supply chain disruptions are the main reasons for this round of inflation in the United States." Yang Panpan pointed out that from the perspective of supply chain, the Role of the Fed's monetary policy is relatively limited, and it can only adjust market expectations to cope with inflation through forward-looking guidance. At the same time, tightening monetary policy means suppressing aggregate economic demand, and in this process, whether we can grasp the degree and balance the two major objectives of inflation governance and economic development is crucial.

Risk spillover

On June 15, the day the Fed announced a rate hike, Brazil's central bank also announced that it would raise the benchmark interest rate from 12.75% to 13.25%. This is the 11th consecutive rate hike by Brazil's central bank since March 2021. Since June, Mexico, Argentina, Peru, Chile and other Latin American countries have also raised interest rates sharply to cope with growing pressures on imported inflation.

Patricio Giusto, director of the Argentine-Chinese Research Center in Argentina, pointed out that the main purpose of the Fed's interest rate hike is to curb high inflation in the United States, but it will cause very serious negative spillover effects on the global economy, especially it will lead to continued price increases in emerging economies in Latin America, increased loan costs, continuous devaluation of currencies, increased people's cost of living, and rising unemployment.

Not just Latin America. In April and May this year, the Bank of Korea raised interest rates by 25 basis points for two consecutive months after 14 years and 9 months; The European Central Bank recently announced that it will create a new tool to protect vulnerable economies in the eurozone while raising interest rates.

"The global economy is changing dramatically." The BBC recently said that the central banks of most advanced economies and some emerging market central banks have recently tightened monetary policy simultaneously, which will have an impact on the business sector and consumers around the world. The Guardian said the Fed's move would increase pressure on global central banks to keep pace with it. India's "Print Newspaper" criticized that "aggressive interest rate hikes may disrupt the market and undermine the economic recovery after the epidemic".

Yang Panpan believes that the Fed's large-scale interest rate hikes will lead to a tightening of domestic demand in the United States, which means that the demand for other economies in the United States will also tend to be weak. Emerging economies will experience more widespread capital outflows and asset allocation readjustment due to tighter liquidity, narrowing spreads and rising risk aversion. Coupled with high global inflation and rising commodity prices, the fundamentals of emerging economies will be impacted. In addition, the current direction of the Fed's monetary policy is still extremely uncertain and unpredictable, coupled with the limited role of macroeconomic policy coordination mechanisms such as the G20, the global economy is facing risks.

"The impact of the Fed's aggressive rate hikes is global. At present, Europe, Latin America and other regions have begun to suffer from the strong impact of spillover risks. Chen Fengying believes that the Fed's sharp tightening of monetary policy may aggravate the turmoil in the global stock market and foreign exchange market, increase the risk of capital outflows and currency depreciation in other countries to a certain extent, and promote the appreciation of the US dollar and the return of cross-border capital to the United States, which is equivalent to "wool" in the world. (Reporter Li Jiabao)

People's Daily Overseas Edition ( 2022-07-05, 10th edition)