US economy, indeed, the global economy, is facing unprecedented times with inflation reaching 40 years high. The Fed, US central bank, continue to raise interest rates to contain this. However, it is causing newer challenges with sharp depreciation of exchange rate for most of the currencies vis-à-vis the dollar. On the other hand, the unemployment rate, an indicator of cooling down of economic activity, continues to remain at over 2-year low. So, where does the US economy stand and where it is headed? A brief attempt to make sense of that.
It all started with the ultra-loose policy, also called quantitative easing (QE), adopted by the Fed during Covid to minimize the impact on the economy. In March’20, Fed’s balance sheet size was about $4.3 trillion which rose to almost $9 tr by March’22 as per Federal Reserve Economic Data (FRED). This means, Fed pumped almost $4.7 tr of liquidity into the market to tide over the Covid crisis. The crisis has now got aggravated by the Russia-Ukraine war, causing sharp increase in fuel and certain commodities prices.
As a result, US inflation stood at 8.2% in Sept’22, down from the peak of 9%+ in June’22 but still over four times the target of 2%. This level of inflation was last seen in early 1980s. Even though fuel & food prices have spiked substantially, even the core inflation rate stands at 6.6%. The situation is quite similar across other developed nations. Inflation in EU region was 9.1% whereas in UK, it was 9.9% in Aug’22.
So, how is the US dealing with it? Obviously, by raising interest rates. US central bank, the Fed, has raised rates by 300 basis points (3 percentage points) since March’22. The tightening is unusual also because rates are being raised in slabs of 75 bps unlike normal instances when it would be raised by 25 bps. And, has Fed been proactive and does it have a handle on inflation? It is pertinent to note that US inflation rate had started climbing in March’21, a good 12 months before the Fed finally raised rates. US Inflation crossed 2% mark in March’21 and reached 4.99% in May’21. Until about Nov’21, US policy makers were debating as to whether the inflation is transitory and driven by supply disruption or is getting entrenched. Fed chose to give benefit of doubt to the view espousing it is transitory and continued to pursue QE till March’22. This was good 10 months even after it reached a level of 5% and there were enough signs that inflation genie is out of the bag.
A rather unusual trend in the current phase is continued strength in labour market despite the QT. Unemployment rate (UR), which stood at 6% in March’21, when inflation started rising, came down to 3.6% in March’22 and stays at that level since then. As per economic theory, QT should dampen economic activity, lesser requirement of workers and therefore, increase UR. But why do we need higher UR or how is this connected with inflation? The reason is – a higher UR would reduce pressure on companies to raise wages as there would be more workers seeking jobs. Higher wages force companies to charge higher prices of products & services leading to a wage-price spiral. Wage growth rate in the month of Aug’22 was 8.57%, lower than the peak of 11.39% in Feb’22 but still not low enough to provide any comfort.
An unintended effect of US QT is flight of capital back to US from across the globe resulting in sharp depreciation of currencies. This happens because yields on US government and corporate bonds become more attractive. Also, institutions who had borrowed funds in the US market and invested elsewhere are repaying those debts as it becomes costlier and ‘arbitrage’ opportunity reduces. Among the worst is Japanese Yen which has depreciated by almost 30%, from about 115 Yen per dollar in March’22 to 149 Yen per dollar now. Japan’s problems are unusual as it has been grappling with low inflation rate, even negative, for long. Inflation stood at 3% in August, not much higher than its comfort level. It is among the few countries which has not yet raised rates.
So, now that Fed has changed course, what is the impact on the economy? The impact of a rate action is felt after about four quarters. This means it is still too early and the impact would be clearer only by June’23. However, US economy has seen a contraction in last two quarters, -1.6% in March’22 and -0.6% in June’22 quarter on annualized basis. As per conventions, an economy is said to be in recession if it contracts for two successive quarters. Why this has not been called out so remains a mystery.
The other critical questions are, how far would Fed have to go to bring down the inflation back to 2% level and how much of the GDP sacrifice would it entail. More importantly, how long will this last? A flashback to 1980s gives some indication. US had inflation of 7.6% in 1978, 11.2% in 1979 and 13.5% in 1980 before easing to 10.3% in 1981 and 3.2% in 1983. Fed rates stood at 10.9% in 1978, 17.6% in 1979, 22% in 1980 and peaked at 22.36% in 1981! Thus, Fed rate was 22% in 1980, a year before inflation started easing.
And how the GDP performed then? GDP growth was 3.2% in 1979, -0.26% in 1980, 2.5% in 1981 and -1.8% in 1982. Growth reached 4.6% in 1983 and sustained thereafter, marking the normalization of the economy. Comparing current condition with 1980s, even if it assumed that inflation may have peaked, it would take at least two years for it to come down to acceptable level. While the fed rate is nowhere near the peak reached then, conditions may not necessitate such harsh actions now.