The Fed’s solution might be worse than the problem

The chances of a hard landing, with the nightmare prospect of stagflation, are significant, indeed far higher. Photo: AFP
The chances of a hard landing, with the nightmare prospect of stagflation, are significant, indeed far higher. Photo: AFP


  • It is more plausible to argue that inflation in the US, as elsewhere in the world, is being driven by supply-demand imbalances.

The Federal Reserve System, the central bank of the US, has increased its benchmark interest rate, from near zero in mid-March 2022 to 3-3.25% in late-September 2022, in five hikes over the past six months, and projections place it in the range of 4.5% by end-2022. This rate is a benchmark for every other interest rate in the US economy, from borrowing rates for mortgages to business loans. It also influences, often determines, many other interest rates across the world.

The stated objective is to control inflation in the US, which reached a peak of 9.1% per annum in June 2022, the highest in four decades, and is in the range of 8.5% since then. It might seem that real gross domestic product (GDP) growth in the US was robust at 5.7% in 2021. However, given the negative growth at -3.4% in 2020, combined with -1.6% and -0.6% respectively in the first and second quarters of 2022, US GDP in mid-2022 is roughly where it was in 2019. Employment levels have recovered better. The unemployment rate has dropped from 5% in 2019 to 2.5% in July 2022.

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Such sharp increases in the benchmark Federal funds rate—the main monetary policy tool in the US—is puzzling at this juncture. It is bound to dampen growth when the economy is already in a downturn, for the post-pandemic recovery barely made up for the earlier contraction in output. The recent hikes will raise all interest rates in the economy. The actual increase in the cost of borrowing will depend on the maturity-profile and the credit-worthiness of the borrower. Interest rates for business loans will rise sharply to squeeze if not stifle investment. Borrowing by individuals for consumer durables such as cars, or for houses, will become more expensive, squeezing consumption and reducing aggregate demand, which is bound to have multiplier effects. Thus, the consequences of higher interest rates, both on the supply side and the demand side, could further dampen the fragile growth in output and hurt the modest recovery in employment.

The facts about inflation are important. From 2012 to 2020, consumer price inflation in the US was in the range 1-2% per annum, with the average annual rate at 1.6%. Inflation in the US rose to 7% per annum only in 2021.

The efficacy of any policy instrument in curbing inflation depends upon an understanding of the essential underlying cause, just as a doctor’s prescription will cure a patient only if the diagnosis is correct. The critical question, then, is what is driving inflation in the US? In situations where prices are being driven up by excess liquidity, tightening monetary policy using higher interest rates could—but might not always—curb inflation. If that was the diagnosis, interest rates—almost zero for two years from March 2020 to March 2022—should have been raised earlier, when inflation gathered momentum in 2021. But the monetary policy response followed with a considerable time lag. The belief that excess liquidity is driving inflation is not quite plausible, as the era of near-zero interest rates and quantitative easing ended in 2016. However, in response to the covid crisis, the benchmark rate, above 2% in late 2019, was lowered to near-zero by March 2020, and the Fed expanded its lender-of-last-resort role for a short period, increasing its balance sheet from $4.5 trillion to $7 trillion between March and May 2020; but this was done only to mitigate the devastating consequences of lockdowns on output and employment, particularly for small businesses (manufacturing and services alike) and laid-off workers who lost their livelihoods. The liquidity eased economic hardship and distress at the time. How did excess demand or excess liquidity surface in this situation?

It is more plausible to argue that inflation in the US, as elsewhere in the world, is being driven by supply-demand imbalances. There are four underlying factors. First, the covid pandemic not only led to a contraction in output because of prolonged and repeated lockdowns in economies everywhere, including the US, but also because it disrupted global supply-chains, which led to a contraction in the supply of consumer goods provided by imports in normal times, particularly in the US. Second, just as the world economy was beginning to recover, the Russia-Ukraine war, which started early 2022, disrupted global supply-chains, particularly in food and fuels. Third, consequences of climate change such as heat waves, or floods, led to a sharp drop in agricultural production, which also reinforced inflation in food and necessities. Fourth, China’s continuing zero-covid policy has reduced the supply of manufactured consumer goods in the world market.

Given these underlying factors, rising interest rates are likely to dampen investment and reduce consumption, thereby leading to a contraction on aggregate demand which is bound to have multiplier effects on output, while leading to plummeting house prices and stock markets. Financial distress could also lead to bankruptcies. The US economy, already in a downturn, could well slip into a recession. Fighting inflation using higher interest rates, could belie hopes of a soft landing with moderated inflation which also revives output growth and employment expansion. This belief, embedded in the orthodoxy of central banks everywhere, represents a triumph of hope over experience. The chances of a hard landing, with the nightmare prospect of stagflation, are significant, indeed far higher. The intended solution, then, could turn out to be worse than the problem, not only for the US, but also for countries elsewhere because its unintended consequences will inevitably spread to the world economy.

Deepak Nayyar is emeritus professor of economics, Jawaharlal Nehru University.

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