Home / Opinion / Views /  Mint Explainer: Why the US Fed struggles to control inflation

President Biden may believe the pandemic is over, but the US economy continues to battle the after-effects of covid. The Federal Reserve is doughtily firefighting inflation, but an overheated US economy is remarkably resilient, with prices remaining elevated despite five rounds of rate hikes already in 2022. Job market and wages remain relatively buoyant, and more rate hikes appear imminent. Inflation in the US is, in part, a result of the Fed’s expansionary policies during the pandemic. The Ukraine war has only aggravated supply chain bottlenecks. For India, a global slowdown – or even a recession – may help in keeping inflation in check, but an erratic monsoon poses fresh challenges.

Why is the Fed so hawkish?

Simply, the US economy is refusing to slow down in double-quick time, as Fed chairman Jerome Powell may have hoped for. The job market continues to remain overheated. There are two jobs for every unemployed American, Powell pointed out in his press conference on Wednesday, an indication that wages may continue to rise in the near term as companies continue recruiting. Higher wages, in turn, force companies to raise prices of goods and services, making it tough for the Fed to moderate inflation. Annual inflation in the US eased marginally to 8.3% in August, but is way above Fed’s targeted 2%.

Powell had said the central bank would continue to use its lending powers “forcefully, proactively, and aggressively”.
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Powell had said the central bank would continue to use its lending powers “forcefully, proactively, and aggressively”.

Already, the Fed has hiked rates five times this year, or three percentage points, and more hikes are likely. The projected federal funds rate for 2022 may mean another 1.25 percentage rate hike this year.

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Powell conceded it’ll be a protracted battle against inflation, and Americans will have some pain to deal with as the Fed attempts to stifle demand, possibly tipping the economy into a recession at some point.

Why is inflation so stubbornly high?

The American economy continues to battle a covid-induced economic crisis. The pandemic may have receded from the US, but Biden may be celebrating too early. Covid has singed the global economy, and it’ll take a while to undo its damage. The Fed now has now to fight the consequences of its expansionary polices, intended to – and did – revive the US economy.

Covid-induced supply side disruptions may have eased, but still remain a concern. China, remember, continues to remain obsessively focused on its zero-covid policy and persists with localized lockdowns. The covid supply-side shock to the global economy has been aggravated by the Ukraine war, putting further pressure on energy prices.

At the moment, the American economy is overheated, as inflation and jobs data indicate. That again is the knock-on effect of the battle against covid. As the pandemic devastated the US economy, the Fed responded with large purchases of US government and mortgage-based securities, and lending to households, businesses and local and state governments.

“We are deploying these lending powers to an unprecedented extent (and) … will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery," Powell had said in April 2020.

And now begins the process of a course correction. Remember, monetary policy shows its impact with a lag, and it may take months, or even a year or two, before it begins to cool the US economy.

Lesson from the Volcker era in the US

In the late 1970s and early 80s, the US was faced with galloping inflation, at over 11%. The Fed's then chairman Paul Volcker raised the Fed funds rate to a staggering 17%, pushing the US into a recession in early 1980. But then, Volcker began easing rates, too early perhaps, as inflation began easing. As prices surged again, the Fed again raised rates to over 19%, which led to a second US recession in July 1981.

In hindsight, many believe Volcker began lowering rates too early, something that Powell would want to guard against. In fact, Powell on Wednesday asserted the central bank would persist with its hawkish stance until inflation settles at about 2%.

The implications for India

In India, too, the Reserve Bank of India has been raising rates to battle retail inflation, which is still above 7%. Further rate hikes appear likely, but a possible global recession will help the RBI to an extent. Easing global commodity prices, particularly crude, may mean the central bank will settle for a moderate hike in rates, instead of a more hawkish stance. Of course, the rupee may remain under pressure in the near term, which could neutralize some of the gains from cheaper energy by making imports costlier.

But the RBI and finance minister Nirmala Sitharaman will remain concerned about an erratic monsoon this season which has hit kharif crop output, including paddy. It could stoke inflationary expectations and put pressure on food prices, making monetary-policy making challenging for governor Shaktikanta Das.

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