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Thursday, June 16, 2022
The Fed Faces Tougher Challenges Ahead
Wei Hongxu

On June 15, the Federal Reserve announced the results of its latest monetary policy meeting, approving a 75 basis point interest rate hike, the highest one-time increase in nearly three decades. At the press conference, Fed chair Jerome Powell said that inflation has unexpectedly risen since the May meeting. In response, the Fed decided to sharply raise interest rates. The next meeting is most likely to be 50 basis points or 75 basis points, and the move to raise rates by 75 basis points is not expected to become the norm. According to the decision of the last meeting, the Fed began to shrink its balance sheet from June 1, and planned to reduce its holdings of assets by USD 47.5 billion every month, which would increase to USD 95 billion after three months. The market had already anticipated that the Fed might take aggressive interest rate hikes, and this was exactly what happened, showing its determination to curb inflation in the short term. For this reason, some analysts believe that this will help restore the market's confidence in U.S. monetary policy. However, many are worried about whether the U.S. will drive the global economy into a quagmire of recession under the aggressive tightening policy, adding to the increasingly pessimistic global economic outlook.

Researchers at ANBOUND are of the opinion that the Fed’s unconventional tightening policy is to resolve its post-pandemic easing policy, and to make up for last year's policy mistakes where it asserted inflation was “transitory”. At the same time, in the context of the "politicization" of the inflation issue, its intention is to coordinate with the "mid-term elections" of the Biden administration, so as to avoid the Democratic Party from losing votes due to uncontrollable inflation. Controlling inflation has become the Fed's primary policy objective right now, even if the economy gets cooling down. While the Fed has made a choice between controlling inflation and maintaining growth, it does not mean that the contradiction will disappear. Instead, it will rebound like a seesaw, and the future will face more severe challenges.

Powell said that the next meeting is most likely to be 50 or 75 basis points, and that 75 basis points of interest rate hikes are not expected to become the norm. The pace of rate hikes will depend on future data. The federal funds rate is expected to be raised above 2.0% and below 3.0% by the end of summer 2022. It is hoped that by the end of 2022, interest rates can be raised to a restrictive level of 3.0%-3.5%. The dot plot shows Fed officials expect the benchmark rate to rise to 3.4% by the end of this year and 3.8% by the end of 2023. Corresponding to this unexpected rate hike, the Fed has already started to shrink its balance sheet in June. This "double tightening" policy will not only have an impact on the U.S. and global capital markets, but also inevitably affect the U.S. economic demand. Regarding the risk of a U.S. recession, Powell believes that after a slight decline in the first quarter, overall economic activity appears to have picked up, and the demand side of the economy is still running red-hot. He stated that the Fed will not try to induce a recession in the U.S. right now, and that the U.S. economy is well prepared for the FOMC to raise interest rates, adding that real GDP growth has picked up in the second quarter. He noted that there is no progress on inflation falling, though the Fed would like to see signs of that. Powell also expressed that wages are not responsible for the current high U.S. inflation, and there is no wage-price spiral.

Powell remains confident in the U.S. economy. Indeed, judging from the employment and other data, the U.S. economic growth remains healthy. However, the U.S. capital market has begun to show signs of adjustment. Not only U.S. stocks have retreated, but the bond market has also fluctuated, driving the yields of government bonds with reference significance to rise sharply. At the same time, the real estate market, which has performed well after the pandemic, will also be affected by the sharp rise in interest rates, and there are signs of "topping". These economic and financial changes, as well as the slump in consumer demand brought on by high inflation, mean the outlook for the U.S. economy is not as rosy as Powell had painted. Raising interest rates and shrinking the balance sheet too quickly is bound to have a significant inhibitory effect on the U.S. economy. Even if economic growth does not fall into recession, it will decline as inflation falls, which will intensify contradictions such as debt, investment, and distribution.

At the same time, Powell mentioned that the Fed will carefully study why U.S. inflation is “stubbornly high", indicating that the Fed's aggressive interest rate hike policy may have limited effect on curbing inflation in the short term. Deep-rooted inflation has both demand and supply-side structural factors, which means that after the inflation level falls, it will still be higher than the Fed's 2% policy target for a certain period of time. Therefore, as the Fed's roadmap shows, the pace of the rate hikes will not stop anytime soon, and may continue to increase until the mid-term elections. Under the maintenance of inflation and the downward trend of the economy, the dilemma that the Fed will face in the future has become more prominent.

The "overshoot" of the Fed's monetary policy will not only have a huge impact on the U.S. economy, but will also drag global central banks into monetary policy tightening, which is bound to hurt the global economy. Some media reported that at least 60 central banks around the world have taken tightening actions earlier than the Fed or followed it during the year, while some have also adopted multiple rounds of interest rate hikes. Many economists have warned that the recent wave of rate hikes is only the beginning of a global tightening cycle. In Europe, Japan and others, global financial conditions will need to tighten further in order to re-anchor inflation expectations. Researchers at ANBOUND pointed out that under the expectation of global central bank policy tightening, economic growth will decline in tandem with inflation falling from a high level, and a new balance of coexistence of low growth and moderate inflation is likely to happen. It should be noted that the current global economic, trade, financial, and monetary environment is undergoing drastic changes, and it would be difficult for future development to return to the pre-pandemic "normal" model, which will exacerbate the trend of global economic fragmentation.

Final analysis conclusion:

The Federal Reserve's tightening policy means that it has made a "politicized" choice between controlling inflation and maintaining growth. This will inevitably affect the U.S. and the global economy. This means that there will be more prominent contradictions in the future. As such, one cannot rule out the change of government in the United States due to the failure of sharp interest rate hikes.

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