Fed’s inflation fight could ruin the economy it seeks to save

It is time for US central bank to reset its policy intentions as encouraging employment data suggests the worst may be over

The markets are gripped with a growing sense of dread that the Federal Reserve is about to push the US economy over the edge into a deeper recession in its quest to stamp out inflation. However, there is another side to debate – the question of whether the central bank should do this at the expense of economic confidence, sustainable recovery and global financial stability.

After all, the US economy is already in recession, borrowing costs have shot up in recent months and market confidence is wobbling. While expectations are high that the Fed will hammer through a fourth successive interest rate increase of 75 basis points in November, it could instead blink and pivot interest rate policy away from overkill. The jury is still out.

The Fed came into rate tightening late in the day, but it does not follow that it will make the same mistake and end up behind the curve when it is time to ease off the monetary brake.

Clearly, the Fed has a good case to keep tightening. Core inflation is running above 6 per cent when it should be closer to the central bank’s 2 per cent inflation target, especially when the economy is running at full employment.

If the Fed’s mandate is to keep price rises under stricter control, then it has some catching up to do, even if the economy has slipped into negative growth in the past two quarters, the textbook definition of a technical recession.

The US economy is not showing all the hallmarks of a true recession, though, with the latest employment data last week underlining the Fed’s dilemma. The headline non-farm payrolls are doing fine, with 263,000 jobs added in September, in line with expectations and just a little lower than August’s 315,000 headline rate.

But it is the jobless rate, dropping from 3.7 per cent to 3.5 per cent in September, that highlights how strong the US labour markets are despite the economic downturn. That is the lowest unemployment rate for more than 50 years, fuelling Fed angst that the demand for labour is feeding into a dangerous wage-price spiral.

Fed concerns should be allayed, though, by signs that US wage inflation pressures are starting to wane. In September, the annual growth in average hourly earnings eased back to 5 per cent from 5.2 per cent the previous month and from a post-pandemic peak of

5.6 per cent earlier in the year.

If market perceptions that global energy prices have peaked and headline inflation rates are already on their way down are vindicated, then there is light at the end of the tunnel.

This week’s consumer price index data should be an important test, with headline inflation expected to ease down to 8.1 per cent in September from June’s 9.1 per cent peak. The odds are that we have probably seen the worst of inflation and there is no need for Fed overkill.

Of course, the Fed can drive rates as high as it likes, maybe up to the heights of 1981 when the Fed Funds rate approached 20 per cent. It would be driving out inflation at the cost of deflation, though, and the US economy is in no shape for another toxic interest rate shock.

Monetary policy has already been tightened considerably in recent months. Short-term interest rates have been driven higher, mortgage rates have increased and the long-term cost of borrowing has jumped for companies and the government as stocks have fallen and bond yields have pushed higher.

What’s more, the stronger US dollar, which is up significantly in the past year on a trade-weighted basis, has imposed a severe squeeze on the manufacturing sector, the monetary equivalent of an extra 4 to 5 per cent on short-term interest rates. At the same time, the US budget deficit has fallen dramatically in the past year because of fiscal drag, with the risk of more tightening on demand.

This is a supply-side, cost-push price shock, not a demand-pull inflation phenomenon, and it is outside the Fed’s toolkit to be able to deal with it rationally and responsibly. It is not the Fed’s mandate to drive the economy any deeper into recession. Non-inflationary, sustainable growth remains its primary goal. It is time for a breather and a reset in policy intentions.