Could the Fed push the US economy into recession? | business | Economic and financial news from a German perspective | DW

Typically, a central bank tightens monetary policy when an economy is overheating and halts or slows rate hikes when they start to cool. But for the first time since the 1980s, the Federal Reserve has raised interest rates amid a slowing economy.

The Fed was late in reacting to rising inflation, insisting post-COVID-19 supply chain problems were only “temporary”. While US prices started to rise in March 2021, the Fed only started raising rates a year later, first by 25 basis points, then by 50, and then by 75 basis points in the last three meetings – effectively emergency measures.

It has now been 19 months since US inflation was close to the Fed’s 2% target. In particular, the cost of groceries, petrol and housing have risen dramatically, and in June the consumer price index (CPI) reached 9.1%, its highest level in more than 40 years.

Inflation falling, Fed still hawkish

Despite signs that inflation may have peaked now – the CPI settled lower at 8.3% in August – the Fed says it will keep raising rates until the inflation monster is tamed.

The Fed’s continued hawkish stance and accusations of being behind the curve have raised concerns it could push the US economy into recession.

“The truth is that nobody can be sure how clear and present a recession threat is in the US,” Daragh Maher, head of research (Americas) at HSBC Bank, told DW. “But the more persistent inflation is, the greater the risk of recession.”

Maher added that weaker growth is not “an acceptable side effect of this inflationary war” but “a necessary element”.

Indeed, policymakers fear the prospect of stagflation – the combination of sluggish economic growth and persistently high inflation seen in the 1970s and early 1980s.

US food inflation hit 11% in August

The Fed has few options

Some have questioned whether the Fed’s current approach resembles that of 1979, when then-Fed Chairman Paul Volcker squashed inflation with a series of historic rate hikes, but sparked a two-year recession that saw the US unemployment rate hit 10%.

Financial markets have now priced in a fourth straight rate hike of 75 basis points in November, with some analysts awaiting further guidance.

“I think 75 is the new 25 until something breaks and nothing has broken yet,” Bill Zox, a portfolio manager at Brandywine Global Investment Management, told Bloomberg News, adding that he believes the Fed is nowhere near a pause or panning .

Could more rate hikes lead to market instability?

Warnings of further rate hikes grew louder this week, first from veteran market analyst Ed Yardeni, who predicted tightening would be a blunt tool that risked destabilizing financial markets.

“If you also have QT2 [quantitative tightening] and a rising dollar, there are very restrictive monetary developments,” Yardeni told Bloomberg News. “I think they have another rate hike in November and that will be it because the issue of financial stability will emerge as the main concern.”

Signs of vulnerability have already been seen from European banks such as Credit Suisse and the run on sterling, which forced the UK central bank to intervene in the bond market to protect the country’s pension funds.

Rate hikes in the West hurt developing countries

The United Nations has also taken a stand on the issue, warning on Monday that rate hikes by the world’s richest nations risk a painful global recession that would hurt developing countries the most.

The UN Conference on Trade and Development (UNCTAD) said the Fed’s monetary tightening, along with the Bank of England and the European Central Bank, was an “unwise gamble” that could dangerously backfire.

According to UNCTAD, the reason for high inflation is not so much excessive demand for goods and services as ongoing trade problems and rising food and energy prices.

HSBC’s Maher noted how the Fed’s dovish stance has prompted global investors to seek safe haven in the dollar.

The US currency has appreciated against most other currencies over the past year, which has exacerbated inflation in the rest of the world as many commodities such as oil are valued in dollars.

“Excessive currency weakness can in turn create other pressures, for example on imports,” Maher told DW. “A number of countries, including in Europe, are seeing deteriorating trade balances” while inflation remains stubbornly high, which could mean “further rate hikes are to come even if inflation slows,” he added.

Edited by: Ashutosh Pandey