US Fed’s long shadow over central banks around the world

High inflation has become a headache for the US economy. Its central bank, the most powerful institution in the global economy, was slow to react to rising signs of rising inflation, and it has come under fire for falling behind the curve.

In a much-anticipated speech Friday (August 26) at the annual US Federal Reserve’s convention in Jackson Hole in Wyoming, its chairman Jerome Powell laid out his intention in clear terms since beginning a cycle of aggressive tightening in March. Inflation is the highest in the country in four decades. The message of the eight-minute-long speech was that US inflation is still strong enough for its central bank to breathe easier, dashing hopes of a rate hike or “soft landing” as soon as possible. As Mr. Powell said. Raising those expectations a few weeks ago. The speech sent global financial markets into decline. Investors who have been underestimating the Fed’s determination to tackle high inflation are now reassuring how tight US monetary policy can be, and how slow economic growth may be as a result.

The Fed has raised benchmark interest rates by 2.25 percent this year. Still, “high inflation continues to spread through the economy”, Mr. Powell in Jackson Hole said in an apparently flamboyant message. There is “clearly one thing to do” to get inflation under control, and that the Fed will “keep it up,” he went on. He cautioned that a “sustained period of downward-trend growth” would be required to contain inflation.

signs of more economic pain

The growing risk is that as it comes to grips with high inflation coupled with aggressive monetary tightening, the Fed will only exacerbate the pain in the global economy. Aggressive interest rate hikes could push the US economy into a complete recession (its GDP has already contracted for two consecutive quarters) and global growth into a deep recession.

The rapid tightening by the Fed will have an impact on the global economy. Global financial conditions are likely to tighten further. Emerging market economies, and especially low-income economies, are particularly vulnerable. Their sovereign debt would become more expensive. Weak currencies have made their fuel and food imports more expensive. The fear is that dwindling foreign exchange reserves could put many like Sri Lanka and to a lesser extent Pakistan in severe debt trouble.

In other words, the economic outlook is not very good. Inflation is now the top concern of all economic policy making. The thinking is that if policy makers still fail to act decisively to control inflation, even if by sacrificing growth, the consequences will be worse later, as higher inflation can penetrate deeper. , which necessitates an even greater increase in interest rates, leading to a prolonged recession or, worse, a recession. And since much of the inflation is coming from the supply side that monetary policy tools can hardly correct, central banks may have to sacrifice more growth, taking more pains to restore price stability.

Critics of the Fed, such as former US Treasury Secretary Larry Summers, have long believed that if the central bank had reacted sooner, inflationary pressures could have been exacerbated with small growth sacrifices.

It is true that central banks across the country are stubbornly trying to control inflation in times of extreme uncertainty and volatility; And that their task has been made difficult by a series of crises triggered by supply chain disruptions caused by the COVID-19 pandemic and lockdowns, particularly in China, with extreme restrictions. Fiscal excesses related to COVID-19 overheated the US economy. The federal debt in the US is running at around 123% of GDP, slightly less than a record 128% in 2020 immediately after the COVID-19 outbreak, but still in the aftermath of World War II-era spending growth Above anything seen from. Russia’s invasion of Ukraine this year further complicated economic conditions by precipitating energy and food crises. Many monetary policy observers also attributed the stickiness of inflation to recent reversals in globalization, particularly the movement of labour, which had kept costs down and prices under control. We are entering a new era of high inflation, he says.

Failure to guess?

But the fact remains that inflation spiraled out of control as central banks sustained the wealth creation frenzy well into the post-COVID-19 recovery. The Fed went into an overdrive combating the COVID-19 crisis, and as it continued to pump liquidity into the economy, its balance sheet grew from $2.3 trillion in 2010 to $9 trillion. It was determined earlier this year – rather late – to end currency build-up, to tamp down its bloated balance sheet and to contain inflation by aggressively raising interest rates from extremely low levels. went to signal.

Among those sympathetic to central banks is former Reserve Bank of India (RBI) governor Raghuram Rajan. His defense of central banks is that even though it may not be difficult for them to read the rising signs of inflation, it was difficult to muster up the courage to act, as it would have jeopardized the nascent economic recovery after the COVID-19 shock.

The bottom line is that central banks failed to distinguish temporary from permanent inflationary pressures.

recovery of credibility

Central banks explicitly portrayed inflation as transitory, even as they persisted with “quantitative easing”. The Fed created the same amount of reserves in just four months of 2020, March to June, as it did in its first 100 years, according to economist magazine. The cost of justifying inflation is eroding credibility. Stumbling from stubborn inflation took a toll on the creditworthiness of central banks. When the central bank enjoys the reputation of being soft, it is a difficult task to bring inflation under control.

Pooja Mehra is a Delhi-based journalist and writer