GP Short Notes

GP Short Notes # 636, 19 June 2022

The US: The Federal Reserve's interest rate increase and its global fallouts
Ankit Singh

What happened?
On 15 June, the Federal Reserve increased the much-awaited target interest rate to 1.75 per cent. The increase is the first step to restraining inflation, as the target for inflation is fixed at two per cent, while the average annual inflation for 2022 in the USA is 7.7 per cent. The change of rate stance in stimulating growth has shifted from neutral (~equilibrium- neither stimulates nor restrains growth) to a slowdown/ contractionary. 

Brian Jacobsen at the Allspring Global Investments said: "The Fed is willing to let the unemployment rate rise and risk a recession as collateral damage to get inflation back down. This isn't a Volker-moment for Powell given the magnitude of the hike, but he is like a Mini-Me version of Volcker with this move."

What is the background?
First, the surging inflation. Inflation expectations are due to high brent crude, cooling in house market and challenges to supply chain management. Emerging economies and populist leaders have tended to look inward in recent times to deter the economic impact of lockdowns. 

Second, invoking the Volker moment. In March 1980, as a federal reserve chair, Paul Volker faced a similar situation when inflation was an economic and political challenge for the nation. He increased the fed fund rate and escorted a hard landing of the economy at the cost of higher unemployment. The economy resumed its growth in 1982 with lower inflation at the cost of ever-increasing deficits in the current account of the US. 

Third, the trends in emerging economies. Many advanced and middle-income economies have increased and kept their benchmark interest at a contractionary rate. Bank of England has hiked its interest rates fifth time since May 2022 as the country witnessed inflation soaring at 9 per cent. India also faces the situation of a tight labour market and the need for a slowdown from the demand side to counter the upside risk of inflation; the current policy interest rate is at 4.4 per cent. 

What does it mean?
Economies are at a high systematic risk of protracted low growth. Given the gravity of the US Dollar in petrodollar, forex reserves and investment portfolios, the global financial impact will create a recession for emerging economies in the non-west region.

There will be a domino effect on housing, stock valuation, cryptocurrency, auto loans, credit cards, insurance and energy profiling. This slowdown in the US economy may spur avenues for more reliable energy sources like renewables. To continue with an interconnected yet fragmented world, there is the scope for enhanced transparency on troubled banks and data gaps. 

There is a need to de-hyphenate from dependence on the dollar and explore measures not to let the slowdown in advanced economies impact emerging economies. Chinese digital Yuan is one such contender; on 17 March, Saudi Arabia has recently agreed to sell oil to China in Yuan. Regional currencies other than the dollar in trade is the way forward in the short term to mid-term to preserve the growth scenario-specific emerging economic geographies. Domestic mandates in various economies to rejuvenate an independent market niche can be a more peaceful way to emerge out of current geo-political turmoil in the world order transition.

The Chinese economy has been in a trade war with the US over threats to its economic vitality. Both sides recently have reduced the bar in tariff wars, but consensus on many trade and investment issues is nowhere in sight. 

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