The Fed’s Solution Could Be Worse Than the Problem

The stated objective is to contain inflation in the US, which reached a peak of 9.1% per annum in June 2022, the highest in four decades, and has remained in the 8.5% range since then. It may seem that real gross domestic product (GDP) growth in the US was stronger at 5.7% in 2021. However, given negative growth of -3.4% in 2020, with -1.6% and -0.6% in the combined first and second quarters of 2022, respectively, US GDP in mid-2022 is roughly where it was in 2019. . The level of employment has improved. The unemployment rate has come down from 5% in 2019 to 2.5% in July 2022.

Such a sharp hike in the benchmark federal funds rate—the main monetary policy tool in the US—is confusing at the moment. When the economy is already in recession, it is bound to curtail growth, as the post-pandemic recovery barely made up for the earlier contraction in output. The recent hike will push up all interest rates in the economy. The actual increase in the cost of borrowing will depend on the maturity-profile and credit-worthiness of the borrower. Interest rates for business loans will rise sharply if investment is not suppressed. Borrowing by individuals for durable consumer goods such as cars, or homes will become more expensive, reducing consumption and reducing aggregate demand, which is bound to have a multiplier effect. Thus, the consequences of higher interest rates, both on the supply side and on the demand side, can further curtail delicate growth in output and hurt modest improvements in employment.

The facts about inflation are important. From 2012 to 2020, consumer price inflation in the US was in the range of 1–2% per year, with an average annual rate of 1.6%. Inflation in the US rose to 7% per annum only in 2021.

The effectiveness of any policy instrument in curbing inflation depends on an understanding of the underlying cause, just as a doctor’s prescription will treat the patient only if the diagnosis is correct. In such a situation, the important question is, what is driving inflation in America? In situations where prices are driven by more liquidity, tightening monetary policy by using higher interest rates can curb inflation—but not always. Had this been the diagnosis, interest rates—nearly zero for two years from March 2020 to March 2022—should have already been raised, when inflation picked up pace in 2021. But the monetary policy response has been with a considerable time lag. The belief that excess liquidity is driving inflation is not quite plausible, as the era of near-zero interest rates and quantitative easing came to an end in 2016. However, in response to the COVID crisis, the benchmark rate at the end of 2019 was above 2%. reduced to nearly zero by March 2020, and the Fed expanded its lender-of-last-resort role for a shorter period, expanding its balance sheet from $4.5 trillion to $7 trillion between March and May 2020; But this was only done to mitigate the disastrous consequences of the lockdown on production and employment, especially for small businesses (similar to manufacturing and services) and workers losing their livelihoods. Liquidity eased the economic hardship and crisis at the time. How did the excess demand or excess liquidity surface in this situation?

It is more plausible to argue that inflation in the US, as elsewhere in the world, is being driven by a supply-demand imbalance. There are four underlying factors. First, the COVID pandemic not only caused production contractions due to prolonged and repeated lockdowns in economies everywhere, including the US, but also because it disrupted global supply-chains, leading to increased supply of consumer goods. There was a contraction. Imports in normal times, especially in America. Second, as the world economy began to recover, the Russo-Ukraine War, which began in early 2022, disrupted global supply-chains, particularly in food and fuel. Third, the consequences of climate change such as heat waves, or floods, caused a sharp drop in agricultural production, which also fueled inflation in food and necessities. Fourth, China’s continued zero-Covid policy has reduced the supply of manufactured consumer goods to the world market.

Given these underlying factors, rising interest rates are likely to reduce investment and reduce consumption, leading to a contraction in aggregate demand, which has a multiplier effect on production, while declining home prices and stock markets. Financial crisis can also lead to bankruptcy. The US economy, which is already in a recession, could be in the grip of a recession. Fighting inflation by using higher interest rates can bolster expectations of a soft landing with moderate inflation which also revives production growth and employment expansion. This belief, rooted in the conservatism of central banks everywhere, represents the triumph of hope over experience. The probability of a hard landing is significant, with the nightmare of stagflation likely far higher in fact. The intended solution could be worse than the problem, not only for the US, but for other countries as its unintended consequences would inevitably spill over into the world economy.

Deepak Nayyar is Emeritus Professor of Economics at Jawaharlal Nehru University