THE U.S. Federal Reserve last Wednesday raised its benchmark interest rate by 75 basis points, marking the sharpest rate hike since 1994, as inflation data released in recent days indicates no clear sign of easing.

Though necessary to bring inflation under control, the Fed’s more hawkish stance could plunge the U.S. economy into a recession, dealing another blow to the Biden administration and dampening Democrats’ prospects in the upcoming mid-term elections.

The U.S. central bank’s faster monetary tightening could also create spillover effects, hitting emerging markets and low-income countries, leading to a global financial rout.

Record inflation

After a two-day policy meeting, the Federal Open Market Committee (FOMC), the Fed’s policy-making body, decided to raise the target range for the federal funds rate to a range of 1.5% to 1.75%, noting that the Fed is “highly attentive to inflation risks.”

The U.S. central bank raised rates by 25 basis points in March, beginning its rate-hiking cycle as surging inflation in the United States smashed records in four decades. It then raised rates by 50 basis points in May. The 75 basis-point rise was the first such move in decades.

Since the May policy meeting, “inflation has again surprised to the upside,” pushing the committee to adopt a larger rate hike, Fed Chair Jerome Powell said last Wednesday afternoon at a press conference.

Statistics from the U.S. Labor Department revealed that the consumer price index skyrocketed 8.6% in May from a year earlier, marking the third straight month of inflation over 8% and hitting a new four-decade high. The figures dashed hopes that inflation had peaked.

“From the perspective of today, either a 50- or 75-basis-point increase seems most likely at our next meeting,” said Powell, leaving the door open for another 75-basis-point rate hike.

The Fed chair noted that the committee would like to do a little more “front-end loading,” meaning the Fed would implement larger hikes early in its rate hiking cycle.

Recession risks up

The Fed’s newly released quarterly economic projections showed that the median FOMC projection for the federal funds rate at the end of this year has jumped to 3.4%, much higher than the 1.9% projected in March. The median projection for 2023 year-end federal funds rate is 3.8%.

The economic projections showed that Fed officials’ median projection of GDP growth in the fourth quarter this year is 1.7%, much lower than the 2.8% projected in March.

Adam Posen, president of the Peterson Institute for International Economics, said that the speeding up or front-loading of hikes “makes little difference to recession risk,” and what matters most is “how high the Fed has to go” to control inflation.

“If they raise the projected terminal rate of this hiking cycle from around 3% to more than 4%, that indicates that they may need a recession to bring down inflation,” Posen said.

According to the estimates of Bloomberg Economics, a downturn by the start of 2024, barely even on the radar just a few months ago, is now close to a three-in-four probability.

Biden’s headache

Surging inflation has inflicted pain on American businesses and households, resulting in a major headache for the Biden administration, especially as the mid-term elections draw closer.

President Joe Biden and his party, who have yet to address the issue with a viable plan, would need to persuade voters that persistently high inflation is not due to policy failure but rather to pandemic-related supply shocks and the Ukraine crisis.

But that could be a tough sell.

“The Fed took a gamble, which was a reasonable one ex ante, to see how low they could drive unemployment. 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,” Posen said.

“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.

A Wall Street Journal opinion piece published last Tuesday argued that the current inflation was “predictable,” blaming the Fed, the Congress and the president for adopting “excessive” fiscal and monetary policies.

Spillover effects

The Fed’s shift to a more hawkish stance could lead to spillover effects on emerging markets and low-income countries, given the U.S. dollar’s essential role in the global financial system.

“We are seeing that high U.S. interest are causing capital to be repatriated out of the emerging market economies, which might now default on their debts and cause global financial market stresses,” said Desmond Lachman, senior fellow at the American Enterprise Institute and a former official at the International Monetary Fund (IMF).

During the April Spring Meetings of the IMF and the World Bank, officials and economists warned about the potential spillover risks of the U.S. Fed’s more aggressive monetary tightening.

It could add pressure to capital outflows in emerging markets, push up imported inflation, increase debt vulnerabilities and reduce policy space, said Malhar Nabar, division chief at the IMF’s Research Department.

“So there is a concern that emerging market economies that have borrowed heavily in dollars, and especially on short maturity, could find themselves in a difficult position,” Nabar said.

“That would lead to a slowdown in their economies,” he said. “Or if they’re not able to meet their debt service obligations, then of course, that would create wider debt problems.”

Posen noted that some low and middle-income economies would have financial difficulties with the Fed sharply hiking rates. “This will particularly hit those which are having difficulties with food and energy price inflation and with large hangovers from COVID-19,” he said.

（Xinhua）