The Fed is ready to choke the US economy to kill inflation

Senior business columnist

The conversion of the US Federal Reserve Board’s rate-setting committee’s members from doves to hawks is complete,with the Fed now pursuing an ultra-aggressive interest rate trajectory to tame the rampant inflation in the US.

The Fed’s Open Market Committee (FOMC) raised the federal funds rate (the US equivalent of our Reserve Bank’s cash rate) by 0.75 percentage points on Wednesday,its third consecutive hike of that magnitude. That lifted the federal funds rate to within a range of 3 to 3.25 per cent,as had been expected. What surprised financial markets,however,were the signals the committee sent about the future path of rates.

The majority of the FOMC members now expect there to be at least one more 0. 75 percentage point increase and another hike of at least 0.50 percentage point before the end of the year. This would raise the federal funds rate to close to 4.5 per cent by the end of this year.

Jerome Powell,chairman of the Federal Reserve.

Jerome Powell,chairman of the Federal Reserve.Bloomberg

Moreover,the FOMC’s median forecast expects the rate above that level next year,with a significant number of the members – about half -- anticipating a peak of almost 5 per cent. The projections for the rest of this year and 2023 are far more aggressive than those the markets had expected and priced in.

The Fed’s belated recognition that the inflation breakout wasn’t,as it insisted last year,transitory almost guarantees a recession in the US.

While the FOMC members don’t necessarily accept that – their median forecast is for real GDP growth to bottom out at 1.2 per cent next year – they have revised their forecasts of growth down and unemployment and the inflation rate up since their projections were last published in June and the Fed chairman,Jerome Powell,has made it clear that containing inflation,not growth,is now the priority.

“We have to get inflation behind us. I wish there were a painless way to do that. There isn’t,” he said at the press conference that followed the meeting.

“Higher interest rates,slower growth and a softening labour market are all painful for the public that we serve. But they’re not as painful as failing to restore price stability and having to come back and do it down the road again,” he said.

The median FOMC projection for unemployment next year has been revised up from June’s 3.9 per cent to 4.4 per cent. There’s never been a 0.5 per cent increase in US unemployment without a recession.

The Fed’s new-found aggression means it is likely that it won’t just be the US that flirts with recession. Most other major central banks are raising rates and siphoning liquidity out of their systems.

Europe,with its particular challenges as a result of Russia’s invasion of Ukraine,is destined to experience shrinking economies even though it badly lags the Fed in raising its policy rates. China’s economy has faltered badly and is stalling because of its COVID policies and the implosion of its property markets.

The simultaneous slowing of the world’s three biggest economies and the global tightening of monetary conditions that the Fed is now leading makes it increasingly likely,perhaps inevitable,that there will be a global recession.

The US dollar spiked again after the Fed’s announcement,to 20-year highs against its major trading partners. It is up about 16.5 per cent against a basket of those currencies this year,placing significant pressure on other central banks to adopt more aggressive monetary policies to defend their currencies and minimise the inflationary effects of currency depreciation.

The Australian dollar is now trading just above US66 cents. A month ago,it was still above US70 cents and as recently as April it was above US75 cents.

By trying to play catch up with an inflation rate that was already entrenched the Fed has been left with no palatable alternative but to choke off inflation by choking the US economy.

The pace and extent of that fall adds to the pressure on the RBA to keep raising the cash rate. The Fed may not dictate global monetary policies,but it heavily influences them via the interest rate differentials and currency relativities.

It also impacts other global financial markets.

Wall Street fell,again on Wednesday,after concluding that the Fed was singularly focused on bringing down the inflation rate and that orchestrating a soft landing is now a far lesser priority.

The FOMC projections make it clear that the committee expects US rates to keep rising and remain higher for longer. The media projection for the federal funds rate in 2024 is 3.9 per cent and even in 2025,it would still be 2.9 per cent and therefore still above the Fed’s targeted inflation rate of 2 per cent.

For sharemarkets that value companies on their discounted future cash flows,the rise in the yields on inflation-protected 10-year Treasury bonds is threatening. Where,at the start of the year,the discount rate – the real 10-year bond rate -- was negative,now it is solidly positive. That will impose even greater pressure on the value of high-earnings-multiple stocks,particularly technology stocks.

The S&P500 fell 1.7 per cent after the rate increase – it’s down 21 per cent this year – and the Nasdaq index,with its bias to technology companies,1.8 per cent. It is down about 30 per cent this year.

The bond market also reacted sharply to the Fed’s announcement,with the yield on two-year Treasuries climbing through the 4 per cent mark last breached in 2007.

It reached 4.05 per cent on Wednesday as traders concluded that there would be no Fed “pivot” -- a switch from tightening policy to loosening it as the economy slows – within the next year or so.

Fighting inflation means slow growth and a weakening of the US labour market.

Fighting inflation means slow growth and a weakening of the US labour market.Bloomberg

The optimists in the market had been pricing in a peaking of US rates by the end of this year or early next year at the latest. Powell’s commentary and the Fed’s famous “dot plot” of FOMC members’ projections,which show the federal funds rate is still expected to be close to 4 per cent in 2024,dashed their hopes.

With the markets now being led by Powell and the Fed to expect at least one more of the supersized 0.75 percentage point rate increases this year,along with either a fifth of that size or at least another 0.50 percentage point,the outlook for the markets (and the economy) is bleak.

Monetary policies are crude tools that impact with lags of uncertain duration. It’s not surprising that Powell declined to rule out the prospect of a recession as a result of the Fed’s policies.

By trying to play catch up with an inflation rate that was already entrenched (partly attributable to overly loose monetary and fiscal policies and partly to the impact of the pandemic on global supply chains),the Fed has been left with no palatable alternative but to choke off inflation by choking the US economy. It seems to have finally accepted that.

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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.

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