The US Federal Reserve has announced its biggest interest rate hike in more than two decades, as it tries to calm inflation, which is at a 40-year high, Fed Chairman Jerome Powell finally acknowledged. That inflation is “too high”. The Fed’s announcement of a 0.5 percent increase in its benchmark interest rate is the most aggressive since 2000. This follows a 0.25% increase in March. Further increases are expected in this tight cycle. Some forecasters say the Fed will raise rates seven times in 2022 to take the benchmark interest rate to 2.9% by the beginning of 2023.
Why did US stock prices rally after the Fed’s rate hike on Wednesday? Powell drew record admiration for his predecessor, Paul Volcker, who 50 years ago wrestled high inflation with raising interest rates at the expense of recession. Still, asset markets viewed them as inferior as they refused to rise by the widely expected 75 basis points at the next meeting. Did asset markets read the Fed correctly?
It depends on how aggressive the Fed will be. Central banks in advanced economies will undoubtedly bring inflation back to the 2% target, but it will take time to bring down inflation. Late in changing gears in the rate hike cycle, the Fed may not be able to bring inflation down to target before 2024. The Fed has gradually moved to act against inflation from concerns over COVID-induced supply-side bottlenecks and energy shocks. War broke out in Ukraine. Demand-driven pressures on inflation from the unprecedented fiscal excesses and Covid-related stimulus packages in the US seem to have been given insufficient importance. The implication is that inflation has hit a multi-decade high, which means the Fed may find it has to be more aggressive on raising rates.
A recession is usually needed to bring high inflation under control. The Bank of England, which had followed the Fed’s hike – the fourth increase since December – also warned that the UK economy was now expected to shrink this year. It is important to note that the US Fed is catching up with the Bank of England which paved the way for advanced economies to act against inflation. Australia’s central bank also recently raised its interest rate for the first time in more than a decade. The Reserve Bank of India also began its tough cycle in an off-schedule decision taken hours before the Fed’s announcement.
As central banks go on a tighter cycle, a financial crisis could ensue if asset bubbles burst from the nearly free money created by the policy of the past few years. The unprecedented level of Covid-fighting stimulus from the Fed pushed up asset prices in financial markets. The second set of Fed decisions that pertain to QT or quantitative tightening. Starting in June, the Fed will shrink its $9 trillion asset portfolio, which will also have the effect of rising borrowing costs, reducing its holdings by $47.5bn per month, and then, after September, it will reduce its holdings by $95bn per month. will start reducing. ,
As the era of free money comes to an end, the discontinuation of incentives could lead to volatility in asset prices and financial markets. The Fed wants to avoid this. It wants to keep the Qt cycle from becoming turbulent like the 2013 taper tantrums. The Powell is expected to deliver a gentle and smooth QT compared to the “soft-landing,” taper tantrums of 2013. But could he really be sluggish? Asset Markets Looks To Bet That Could Be One thing is certain: It’s not going to be easy.
The risk still remains that the US economy will go into recession. And that 2022 will be a year of global economic chaos: wars, public debt shock, inflation, a shift in the policy cycle of central banks from ultra-lax to tight, dollar investment flights in the US, currency volatility, financial instability, Increased uncertainty and increased asset price volatility.
Apart from these headaches, there will also be a risk of global inflation being imported into India. Since the Fed’s rate hike will also strengthen the US dollar, commodity and oil prices will become more expensive for emerging economies. Corporates will find it more expensive to borrow in dollars.