Could the Federal Reserve Tackle Inflation?

Lantao Li

After the latest monetary policy meeting, the Federal Reserve has decided to lift the benchmark federal funds rate by a quarter-percentage point from the current rate of close to zero to a range of 0.25% and 0.5%. Most officials expect that the interest rates would rise at least to levels seen two years ago before the COVID-19 pandemic hit the U.S. economy. In its policy statement, the Fed expresses growing worry about inflationary pressures. According to the statement, inflation has been surging owing to broader pricing pressures, as well as the Russia-Ukraine war and certain connected events. The statement also hints that the Fed might soon announce and implement a plan to shrink its USD 9 trillion portfolios. According to the ANBOUND’s researchers, as the Fed resumes its interest rate rise cycle after a three-year hiatus and begins to decrease its balance sheet concurrently, it demonstrates that its policy priority has shifted back to reaching the inflation objective. If inflation continues to grow, the U.S. economy and Fed policy may face difficulties in the future.

The Fed’s decision to increase interest rates is under market anticipation. Previously, several market institutions predicted a 50-basis-point increase in interest rates. Some also predicted that the balance sheet might be reduced at the same time as the interest rate hikes. Therefore, the present 25 basis point rate hike is considered the most moderate among the market expectations. What makes the market optimistic is the Fed’s views on the U.S. economy. Fed Chair Jerome Powell mentioned that high inflation would linger longer than expected, but the U.S. economic growth would very likely rebound. It is also believed that the U.S. economy could preserve a resilient labor market while restoring price stability. As a result, the authorities do not believe that the U.S. economy will experience stagflation. This explains why the stock market in the United States did not respond strongly to the decision to hike interest rates, but rebounded as soon as policy uncertainty was removed.

With the labor and consumer markets in good shape, the main issue that the Fed may have to deal with for the time being and for some time to come is inflation. They rejected the notion that inflation is transitory and instead insists that it occurs in stages. Their view is that the U.S. inflation risks are skewed to the upside, with the median inflation forecast for this year at 4.3% and the inflation trajectory through 2024 is significantly higher than its December forecast. Powell acknowledges that the high inflation rate will last longer than expected and that inflation might take a longer time than expected to return to the Federal’s price stability target. He believes the Russia-Ukraine conflict is putting a little upward pressure on U.S. inflation in the short term, as it drives up prices of oil and other commodities, and this perpetuates supply chain issues. The Fed anticipates that inflation will stay high through the middle of the year before beginning to fall dramatically in early 2023, when it will revert to its 2% objective, together with the base and the lag effects of monetary policy.

Relative to the rising inflation level in the U.S., the market commonly views that the cycle of rate hikes would accelerate. Powell has stated that the pace of this rate rise will be faster than it was before. According to the median projection of 16 authorities, the federal funds rate would climb to at least 1.875 percent by the end of this year, to roughly 2.75 percent by the end of 2023, and to remain at this level by 2024.

That means there may be a total of seven rate hikes of 0.25 percentage points this year and three to four more next year. This shift is much more rapid than what most officials predicted in December. That pace is also more much agile than the nine rate hikes between 2015 and 2018. That adjustment is closer to the 2004-2006 period when rates were 17 times in a row. The Fed has revealed that it would most likely disclose the balance sheet reduction as early as May. Powell notifies the tightening cycle would be very similar to that of 2017-2019, and it would progress faster and be initiated much earlier than the previous time.

As ANBOUND has pointed out, the rate hike and balance sheet reduction at such a rapid pace this time indicate significant inflationary pressures. The market response and evolution in the face of the accelerated pace of monetary policy in the future remains challenging. After all, in the face of a roughly USD 9 trillion scale reduction plan, as well as an interest rate hike, if the plan to decrease the balance sheet is not well-managed, policy risks will increase. The economy’s resiliency to withstand such a strong currency change in the future is vague. This risk is not only reflected in the changes in the valuation of the capital market, but it will also bring about an increase in the financing cost of the real economy and higher pressure on real enterprises. The already highly inflated real estate market is likely to turn around, creating new shocks to financial institutions. This hypothetical chain reaction might induce another economic crisis in the United States.

As the current intensification of geographical risks has surpassed the impacts of the COVID-19 pandemic, the U.S. economy might face more uncertainties. Although the Fed is not showing signs of worry about the rising inflation rate with the backdrop of the Russia-Ukraine conflict, Powell admits that the it does pose a downside risk to the U.S. economic activities. The financial and economic impacts become highly uncertain, and the volatility in financial markets could tighten credit conditions and affect the real economy. At present, geopolitical risks have become the main factor in affecting the volatility of the capital market. From the market performance, the concern about the risks caused by the war in Ukraine has outpaced the impacts of the changes in monetary policy. With this prolonged instability brought about by the conflict between Russia and Ukraine, it will be more daunting for the Fed to calmly deal with inflation in the future. Some institutions are even concerned that the turmoil brought about by the conflict in Ukraine might cause liquidity issues for some financial institutions. At that time, the Fed will be in a dilemma as to whether it has to broaden its balance sheet to provide economic support.