almost 2 years ago • 3 mins
Central banks around the world are raising their interest rates to tackle red-hot inflation, but it’ll take a lot of skill to make sure they don’t tip into dangerous territory.
✍️ Connecting The Dots
Consumer prices in the US have been soaring over the past year amid a mix of rebounding demand, worsening supply chain issues, soaring commodity prices, and a shrinking pool of workers. The US inflation rate hit 7.9% in February – its highest since January 1982, and almost four times the Fed’s 2% target. And so, after hinting earlier this year that rate hikes are coming very soon, the Fed finally raised interest rates for the first time since 2018 last week.
It also signaled that it intends to hike interest rates at all six of its remaining meetings this year – in line with what traders were pricing in already. What’s more, the Fed hinted that it’ll soon start reducing the size of its enormous balance sheet too, which includes nearly $9 trillion worth of bonds that it hoovered up as part of its efforts to shore up the economy. So when the Fed starts reducing its balance sheet, that aid will wither away with it.
While the Fed said it’s confident the economy can withstand rate hikes, it acknowledged the uncertainty caused by the recent Russia-Ukraine conflict, which will likely increase inflation and dent economic growth. That theory was clear in the central bank’s updated forecasts: it lowered its 2022 economic growth projection from 4% to 2.8%, and increased its core inflation rate forecast – which strips out unstable food and energy prices – by 1.4 percentage points.
1. The Fed has a very difficult task ahead…
The US central bank has the difficult task of trying to engineer a “soft landing” for the world’s largest economy – that is, cooling the economy down while avoiding a recession. If the Fed hikes too slowly, it risks allowing inflation to run out of control. In fact, some critics already think it’s behind the curve in tackling soaring prices. After all, they can become more entrenched if companies pass on elevated costs to consumers who then react by demanding higher wages. On the other hand, if the Fed hikes too quickly, it could end up roiling markets and tipping the economy into recession. In fact, the yield curve – which measures the difference between long- and short-term bond yields – has been getting closer to inverting since the start of the year. That matters: an inversion is when short-term yields are higher than long-term ones, and has preceded every US recession since the 1950s.
2. … and it’s not alone.
The Fed isn’t alone in its difficult task. The European Central Bank made a surprise announcement earlier this month to scale back its bond-buying program faster than planned. That’s a direct response to the war in Ukraine driving up inflation, and also gives the central bank more flexibility around the timing of potential rate hikes, so it can properly assess the economic damage from the conflict. The Bank of England, meanwhile, raised interest rates last week in its third back-to-back increase since December. But it also hinted at a much more cautious path of rate hikes over the coming year, as consumer confidence dips and the squeeze on household finances intensifies.
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