Suddenly, the global inflation/recession debate has become two-pronged. For much of 2022, the mantra on the street was that central banks around the world needed to aggressively raise interest rates in such a way that the dangerously high levels of inflation seen do not drive inflationary expectations. High inflationary expectations that persist for an extended period have a bad habit of creeping in, which has adverse effects, especially on those who are not well off. Slowing down in its fight against price-volatility, the US Federal Reserve has raised interest rates in the US eight times since March 2022, from around 0% to 4.5% now. It is widely expected to raise rates at least twice more to around 5%. The Fed uses the federal funds rate as its policy tool; This is the target interest rate set by the US Federal Open Market Committee (FOMC) for overnight loans between banks.
The probability of a Fed Funds rate increase is easy to observe directly in the form of the yield on the 30-day Fed Funds futures contract. As of today, this metric suggests a 91% chance that the Fed will raise rates by 25 basis points (0.25%) on March 22 and an 82% chance that it will raise another 25 basis points on May 3. After that point, current readings suggest a 60% chance that the Fed will either hold or cut rates.
Against this backdrop of slowing interest rate increases and declining inflation (year-over-year Consumer Price Index inflation in the US was set to peak at 9.1% in June 2022), the US recently added a surprising and massive 517,000 jobs gave information. The Fed’s rhetoric on the cooling US labor market has shifted from a broad attack on inflation to a more targeted one.
This confusing set of signals has generated a spirited debate between those who say the Fed “needs to do more” and others who argue “it may be overdoing it”. Overdoing it in this context increases the chances of recession. The Fed uses a “dynamic factor Markov switching model” to forecast recession risk. The model is indicating only a 5% chance of a recession. Former New York Fed President Bill Dudley said, [US] The Fed plans a 100% recession as it targets an overheated labor market. US recession, but not every reversal has led to a recession.
Economists of every persuasion have started bickering over how to read these numbers. Inflation hawks point to strong labor market demand and say there should be no question of the Fed holding off on its rate hikes until it cools further. Chief among this group of economists is Larry Summers who cautions that the Fed should not relax too quickly and “continue to medicate until the infection is cured and really gone”.
Another school says that while the US labor market is indeed strong, the recent numbers will be revised downwards. Monetary policy operates with a lag, and, according to this group, job growth will decline from a trend of more than 200,000 jobs per month to less than 100,000. Over-reading one month’s worth of data would unnecessarily risk a slowdown. Nobel laureate Joseph Stiglitz believes the Fed raising rates “too high, too fast, too far” will further fuel fears of supply-chain-led inflation.
The monetarist quarter’s argument suggests that since the broad measure of money growth (M2) in the US has been trending down sharply and has now entered negative territory on an annual basis, inflation will fall sharply. This group believes that the combination of negative money growth, also known as quantitative tightening (QT), and interest rate increases lead to rates rising to 6.5%, which is more than enough to rein in inflation. Should be
Yet another group has switched from being aggressive on inflation to being primarily concerned about recession and overdoing by the Fed. Raghuram Rajan and others believe that inflation is coming down as bottlenecks in supply chains are being resolved and demand for home purchases and housing construction has eased. He is convinced that even if there is a recession, the Fed should be able to get away with cutting rates at that point.
From the perspective of emerging markets, including India, this is not an esoteric debate. The relative central bank rate of interest and consequently the developed relative rate of inflation will determine the path of the balance of payments and exchange rates of these countries. If the currency depreciates too quickly, the country will be subject to imported inflation. Particularly vulnerable are countries with large budget and current account deficits and those that depend on crude oil imports. For capital markets, the higher the US interest rate, the lower global flows from hard currencies to emerging markets.
On the other hand, the US recession will also affect a country like India. If technology spending in the US and the import capacity of foreign markets are reduced, it has a direct impact on India’s exports of services and goods, which in turn puts pressure on the current account.
As Raghuram Rajan says, the maze of doing too little (inflation) and the Charybdis of doing too much (recession) makes it very difficult to navigate from here.
PS: “How many are plagued by doubts, how cautious are the wise,” said Homer, author of the Odyssey, the epic that features the twin threats of Scylla and Charybdis.
Narayan Ramachandran is the chairman of Include Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand
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