The Fed Attempts to Eliminate Local Lumps by Losing Weight


On June 16th, the Federal Reserve adopted an unconventional measure of hiking interest rates by 75 basis points in an attempt to appease the market's concerns about inflation. This was the third rate increase after this round of inflation, following 25 basis points in March and 50 basis points in May.

The underlying condition of the current inflation is the money easing since the COVID-19 outbreak, which occurred between March and June 2020 and thereafter, resulting in an increase of 25% in the USD M2 in that year and 12% in the following year. This year, it is expected to drop to 7%, which would be in line with the average of past decades.

However, money easing is only a necessary condition for CPI inflation, instead of a sufficient one, because the additional money may flood to the asset market rather than the consumer market. In fact, the money easing since 2008 led to a sharp rise in the stock market, while inflation remained moderate. After the easing in 2020, the stock market also roared, while the year-on-year growth of CPI did not exceed 3% until April 2021.

The current inflation directly stemmed from the disorder of the global supply chain. In 2020, COVID-19 caused the disruption of the global supply chain, which pushed up the prices of cross-border commodities represented by energy. With the alleviation of the pandemic, the economic demand gradually recovered. By April 2021, the crude oil price had rebounded from the valley when COVID-19 broke out in the United States to the pre-pandemic level — while the global supply chain had not completely returned to normal, and the even weaker supply led to the continuous rise of cross-border commodity prices. At that time, the Fed expected the price bumps to be fully repaired by the end of the year, and in turn decided that the potential inflation would fade naturally.

However, the conflict between Russia and Ukraine deteriorated rapidly in the second half of last year, and market concerns supported and even aggravated the continuous rise of energy and food prices. The war eventually broke out in February, and the global supply chain was hit hard again, which made the shortage of energy and food supply even worse. Due to the strong spillover of the roaring energy prices, the prices of consumer goods in the United States have since soared.

Faced with surging inflation, the Fed could no longer remain calm. In March, following the outbreak of Russo-Ukrainian War, the Fed finally entered an interest rate hike cycle. As discussed earlier, abundant money is a necessary condition for inflation, but the direct driving force of the current inflation is the disruption of the global supply chain of cross-border commodities, including energy. Therefore, the most effective way to suppress inflation would be to expand the supply of energy and other commodities. However, at present, the US government has failed to take measures to alleviate the energy supply shortage. Although Saudi Arabia, United Arab Emirates, Venezuela, Iran and other countries have sufficient crude oil supply potential — which could fully eliminate the tendency of price increases — their political discords with the United States result in obstacles to augment or restore supply.

The next best solution for the Fed to curb inflation is to hike interest rates, which inherently implies inefficiency and severe side effects.

Inefficiency arises due to the fact that inflation caused by excess demand is sensitive to interest rate hikes, while inflation caused by insufficient supply is much less so. Specifically, the underlying demand for energy and food is rigid, while its connection to loan cost is indirect and time lagging. Moreover, continuing to raise interest rates will reduce the vibrancy  of overall economic activities. For example, housing demand will be under obvious pressure, which will eventually restrain energy demand and thus reduce inflation.

The severe side effects of of raising interest rates and shrinking the balance sheet will suppress the overall market demand. L osing weight may help eliminate local lumps, but it will also lead to muscle atrophy to certain extent. In other words, the side effects of hiking interest rates on unemployment rate and economic growth cannot be ignored. Although the United States is likely to maintain a GDP growth rate of around 1%-2% this year, the economic growth will obviously slow down in the first half of next year.

In addition, the FOMC meeting in June made a sudden move to  increase the magnitude of single interest rate hike, which does not mean that the Fed has made major adjustments to its analysis and action plan on the overall economy since March, but instead announce its determination to suppress inflation to the market and appease the market's concerns. That is to say, the Fed will  gradually hike the base interest rate to 4.0%-4.5% by the end of this year.

Dr. Jie Hu is Professor of Practice at the Shanghai Advanced Institute of Finance (SAIF) at Shanghai Jiao Tong University and is a former Senior Economist of the Federal Reserve.