When inflation started creeping up in 2021, most central bankers and economists weren’t worried, Western economies had avoided inflation for the past decade, and the rise was closely linked to the impact of COVID. Governments had shut down economies, it was normal that prices would increase as economies came out of their “induced comas”, but any price rises would be transitory.
The biggest economic news of 2022 was that they were wrong, inflation did not recede, it only grew, reaching in the US, the largest economy in the world, a peak of 9.1% in June, 2022, far beyond what anyone had imagined a few months before. The US Federal Reserve didn’t see it happening, as late as the end of the first quarter of 2022 they not only kept interest rates near zero but were still pumping money into the economy through the purchase of billions of dollars of bonds. It was only in March 2022 that they belatedly recognized their error and began to use their principal tool to combat inflation, raising interest rates to slow demand in the economy, thereby reducing the pressure on prices. The Fed began this change in policy modestly, by raising interest rates 0.25% in March, followed by a 0.50% increase in May, to seriously tighten the screws on the economy beginning only in June with the first of four increases of 0.75% each, followed by the last of seven increases in 2022, of 0.50% in December, to reach a range of 4.25%-4.50% for overnight borrowing, the highest level in 15 years. And they indicated they expected to maintain high interest rates at least until 2024.
Will these moves, the most aggressive since the 1980’s, bring the US economy into recession in 2023, possibly a severe one? Fed Chairman Powell has said: “No one knows whether this process will lead to a recession or, if so, how significant that recession would be. We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”
It is clear that the increase in interest rates will slow down the US economy in 2023, but how much will it take to tame inflation, for how long will the Fed maintain higher interest rates, will there be a recession and if so, how severe? The United Nations predicts a high likelihood of a US recession, whereas the International Monetary Fund (IMF) is more optimistic, predicting that the Federal Reserve will succeed in managing a “soft landing”, reducing inflation without creating anything worse than a possible “mild recession”. The US Chamber of Commerce estimates that current 5%-6% inflation will melt down to close to the 2% target of the Federal Reserve by yearend 2023, giving them the freedom to drop interest rates rapidly in early 2024.
The Federal Reserve has a dual mandate: to keep prices stable AND to maximize employment – this in vivid contrast to the European Central Bank that has only the mandate to keep prices stable – so the Fed seeks to minimize the negative impact on employment of their increase in interest rates.
The decision on February 1 by the Federal Reserve to increase interest rates by only 0.25% reflects this concern and signals a partial shift in their position, they recognize that their strong medicine is working, the index of inflation they use declined to 5% in December, but that is still much higher than the Fed’s 2% inflation target. Chairman Powell indicated that there probably would be an additional two rate increases in 2023, “We will stay the course until the job is done.”
Wall Street thinks inflation will continue to subside quickly, with increasing likelihood that the Fed will begin backtracking and start lowering interest rates before the end of 2023. I don’t agree. As they underestimated the rise of inflation in 2021 and 2022, I believe the Federal Reserve will continue to maintain high interest rates, and even continue to increase them, until they are absolutely certain that they have tamed inflation, and I think this will mean a decline in interest rates not before well into 2024. My view is partially influenced by the recent good news on the strength in the US economy, for example that the US economy experienced a stronger than expected annualized growth rate of 2.9% in the 4th quarter of 2022, and the continued strength in the labor market (latest news is that there were 11 million job vacancies, one million more than expected), a strong economy means continued inflationary pressure, such good news is in fact bad news in terms of the likelihood that the Fed will stop its push to slow down the economy.
The timing of the Fed’s future downward movement in interest rates is critical, particularly in political terms. Democrats will desperately hope the Fed will drop interest rates dramatically during 2024, leaving them with a flourishing economy by the Presidential election in November 2024, while Republicans will no doubt prefer the scenario that the economy will be in recession on the date of the election, with the impact of lower interest rates delayed until 2025. Irrespective of how the Fed moves, one or the other side will accuse it of playing politics.