Walking the wrong path?

The US Federal Reserve raised its benchmark policy rate by 0.75 percentage points for a second straight time; it had raised rates by the same proportion during the previous meeting on June 15. The current hike is, in fact, the fourth since March — taking the key rate from a near-zero to a range of 2.25 per cent to 2.5 per cent. With the Fed clearly indicating that it may make a further hike during the next meeting in September, the rate is expected to peak somewhere around 3.5-3.75 per cent eventually. This amounts to the most aggressive tightening of monetary policy since the 1980s when Paul Volcker had been striving to contain the double-digit inflation in the country. The US Federal Reserve is firm in its commitment to tame inflation which, currently at 9.1 per cent, is exceeding multiple times the target threshold of two per cent. Jerome Powell, the Chair of Federal Reserve, emphasised that “restoring price stability is just something we have got to do”. The idea is rooted in the basic monetary principle of making loans costly so as to balance excess liquidity, which will bring commodity prices down. However, policy experts have raised their apprehension that the Fed reserve’s move to slow down growth may create a recession in the economy late this year or by the next. Their apprehension is backed by historical evidence as Paul Volcker’s relentless rate hikes in the 1980s had resulted in back-to-back inflation. The Fed has however exuded confidence that a recession will be averted in future. Powell stressed that the Fed wants to “see demand running below potential for a sustained period to create slack” but in “just the right amount” that will escape recession. Clearly, the US Fed is walking the tightrope and its confidence can hardly be taken as a surety. Analysts at Goldman Sachs estimate a 50-50 likelihood of a recession within two years. Powell cited low unemployment rate alongside wage growth and job gains to discard the potential risk of recession. He, however, seems to ignore the fact that production and spending are already on a downward slope in the country. In fact, the Fed’s current hike came at a time when growth was already slowing down. The Central Bank’s target of bringing inflation back to the two per cent band in these turbulent times is indeed ambitious. The hikes are contextualized by the fact that the US is set to undergo Congressional elections in November this year. Inflation is a sensitive issue, and once it touches the psychological double-digit mark, it will become highly unfruitful for the Biden Administration. However, it may be wrong to tag US Fed hikes as a purely political decision, as Central Banks of other advanced countries are also resorting to policy rate hikes. It can still be said that the US is banking on the wrong factors. What it is trying to do is to contain inflation by curbing demand whereas the inflation problem appears to have stemmed largely from supply side constraints resulting from the fallout of the Russia-Ukraine war among other things. While it is obvious that the US Central Bank should make efforts to contain inflation, it may also need to consider that geopolitical circumstances are by and large abnormal currently, and pursuing overambitious targets may come with their own fallouts. As a matter of fact, the US Fed is trying to ‘digest’ massive data it has at its disposal before the next meeting in September. Powell has hinted that if the economy continues to slow down, the Fed may “moderate” the hike — which experts place somewhere around 50 percentage points. Seen in a wider perspective, the US Fed appears to be shedding its long-held accommodative stance — which was strengthened further during the pandemic. Developing countries, Including India, need to make required adjustments domestically to avoid any negative fallouts of the rate hikes. The Indian government and the RBI need to make sure that minimal impact is felt on the falling value of rupee, current account deficit and inflation.