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The US Federal Reserve has announced its biggest interest rate hike in more than two decades, as it tries to cool off inflation, which is at a 40-year high, with Fed chair Jerome Powell accepting finally that inflation is “much too high". The 0.5 percentage points increase the Fed has announced in its benchmark interest rate is the most aggressive since 2000. It follows a 0.25 percentage point increase in March. Further hikes are expected in this tightening cycle. Some forecasts say the Fed will raise rates seven times in 2022 to take the benchmark interest rate to 2.9% by early 2023.

Why did American stock prices rally after the Fed’s rate hike on Wednesday? Powell put on record admiration for his predecessor Paul Volcker, who wrestled high inflation 50 years ago with interest rate hikes at the cost of recession. Yet, asset markets perceived him to be dovish because a widely-expected 75 basis point increase in the next meeting was ruled out. Did the asset markets read the Fed correctly?

Depends on how aggressive the Fed will be. Central banks in advanced economies will no doubt force inflation back to the 2% target but getting inflation down will take time. Late in shifting gears into the rate hikes cycle, the Fed may not succeed in bringing inflation to the target before 2024. The Fed has moved slowly to act against inflation out of concerns related to covid-induced supply-side bottlenecks and the energy shock after the war broke out in Ukraine. It appears to have given insufficient weightage to the demand-driven pressures on inflation from the unprecedented fiscal excesses and covid-related stimulus packages in the US. The implication is that inflation has picked up to a multi-decade high which means that the Fed may find that it will have to be more aggressive on rate hikes.

It usually takes a recession to bring high inflation under control. The Bank of England, which followed up the Fed’s hike with one of its own—the fourth increase since December—also warned that UK’s economy is now expected to shrink this year. It’s important to note that the US Fed is catching up with the Bank of England that led the way for advanced economies to act against inflation. Australia’s central bank has also recently hiked its interest rate for the first time in more than a decade. The Reserve Bank of India too initiated its tightening cycle in an off-schedule decision taken hours ahead of the Fed’s announcement.

As central banks embark on the tightening cycle, there could be financial distress if asset bubbles fed by nearly free money made so by the policy of the last few years pop. The unprecedented levels of covid-fighting stimulus from the Fed buoyed asset prices in financial markets. The other set of the Fed’s decisions that relate to the QT or Quantitative Tightening. Starting in June, the Fed will shrink its $9 trillion asset portfolio, which too will have the impact of rising borrowing costs, reducing its holdings by $47.5bn per month and then, after September, it will begin reducing its holdings by $95bn per month.

As the era of free money ends, the winding down of the stimulus can trigger volatility in asset prices and financial markets. The Fed wants to avoid that. It wants to avoid the QT cycle becoming as turbulent as the taper tantrums of 2013. Powell hopes to deliver a “soft-landing", a gentle and smoother QT than the taper tantrums of 2013. But can he really be dovish? Asset markets seem to be betting that he can be. One thing is sure: It’s not going to be easy.

The risk still remains that the US economy would go into recession. And that 2022 will be a year of global economic chaos: There’s war, public debt blow-ups, inflation, shifts in central banks’ policy cycle from ultra-loose to tightening, dollar investment flights back to the US, currency fluctuations, financial instability, increased uncertainty and heightened asset prices volatility.

Besides these headaches, there’s going to also be the risk of global inflation getting imported into India. Since the Fed’s rate hikes will also strengthen the US dollar, commodity and oil prices will become dearer for emerging economies. Corporates will find it more expensive to borrow in dollars.

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