This May 4, 2021, file photo shows the Federal Reserve building in Washington. (PATRICK SEMANSKY / AP)
WASHINGTON – The US Federal Reserve on Wednesday raised its benchmark interest rate by a half percentage point, marking the sharpest rate hike since 2000, and signaled it would keep hiking at that pace at the next couple of meetings.
As the Fed takes more aggressive steps to rein in the highest inflation in four decades, many economists believe that with a mix of high inflation and low unemployment, it would be very difficult for the Fed to bring inflation down without a recession.
Experts say the Fed's more aggressive monetary tightening could pose spillover risks to emerging markets, adding pressure to capital outflows and increasing debt vulnerabilities, which would send shock waves through global financial markets.
Biggest hike since 2000
The Federal Open Market Committee (FOMC), the Fed's policy-making body, decided to raise the target range for the federal funds rate to 0.75 to 1 percent, the Fed said in a statement after a two-day policy meeting.
The committee also decided to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities on June 1, according to the statement.
READ MORE: US makes biggest interest rate hike in 22 years
"Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures," the Fed noted, adding that the Russia-Ukraine military conflict and related events are creating "additional upward pressure" on inflation and are likely to weigh on economic activity.
"The Federal Reserve has begun an aggressive credit tightening cycle, likely the most aggressive since the 1980s," Diane Swonk, chief economist at major accounting firm Grant Thornton, wrote in a blog.
I think by the end of this year, say in the fourth quarter of 2022, in the first quarter of 2023, a recession is very likely.
Gary Hufbauer, Ex-US Treasury official
In mid-March, the Fed raised its benchmark interest rate by a quarter percentage point to a range of 0.25 percent to 0.5 percent from near zero amid persistently high inflation, marking a major step in exiting from the ultra-loose monetary policy enacted at the start of the COVID-19 pandemic.
The Fed usually lifts interest rates by a quarter percentage point, and the newly announced half-percentage-point rate hike, along with an imminent move to shrink its $9-trillion balance sheet, indicates the urgency to get surging inflation under control.
According to data released by the Commerce Department last week, US personal consumption expenditures price index, the Fed's preferred inflation measure, soared by 6.6 percent in March over the past year, well above the Fed's 2-percent inflation target.
"I think the Fed went way, way too far in the quantitative easing and the zero interest rates," Gary Hufbauer, a former US Treasury official and nonresident senior fellow at the Peterson Institute for International Economics, recently told Xinhua.
Hufbauer believed the Fed should have acted much sooner. He noted that by the middle of last year, the job openings relative to unemployment, the so-called Job Openings and Labor Turnover Survey data, already reached "very high levels," indicating that inflation is going to climb regardless of the supply chain situation.
"The labor market is extremely tight, and inflation is much too high," Fed Chair Jerome Powell said Wednesday afternoon at a press conference, noting that the Fed is moving "expeditiously" to bring inflation back down.
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Powell told reporters that there is "a broad sense" on the committee that additional 50-basis-point interest rate increases should be "on the table" at the next couple of meetings.
As discussed in its March meeting, the Fed will allow up to $30 billion worth of Treasury securities and up to $17.5 billion worth of agency debt and agency mortgage-backed securities to roll off the balance sheet starting June 1. After three months, the monthly caps will jump to $60 billion and $35 billion respectively.
Recession fears grow
There's no historical experience that suggests with such high inflation, the Fed is able to bring inflation down to its 2-percent goal without a recession, said Hufbauer. Analysts often refer to recessions as two consecutive quarters of contraction in gross domestic product.
"We're gonna have a recession," Hufbauer said, noting that the only question is when the recession really starts.
"I think by the end of this year, say in the fourth quarter of 2022, in the first quarter of 2023, a recession is very likely," he said.
Desmond Lachman, senior fellow at the American Enterprise Institute and a former official at the International Monetary Fund (IMF), also highlighted the possibility of an economic recession, arguing that another reason for pessimism is the recent inversion in the yield curve.
"The 2-year government bond yield has unusually exceeded the 10-year bond yield. In the past, such bond yield inversions have very accurately forecast the onset of a recession within six to twenty-four months," Lachman told Xinhua.
"Perhaps even more troubling is the likelihood that Fed policy tightening could burst our current equity and housing market bubbles," Lachman added.
Former Fed Vice Chair Roger Ferguson told CNBC in an interview on Monday that "a recession at this stage is almost inevitable," noting that the central bank won't be able to address the supply side of the issue, which is driving most of the inflation problem.
There is a concern that emerging market economies that have borrowed heavily in dollars, and especially on short maturity, could find themselves in a difficult position.
Malhar Nabar, Division chief, Research Department, IMF
Asked about recession risks, Powell told the press conference that "we have a good chance to have a soft or softish landing or outcome," noting that "there is a path to that," which would allow the Fed to get inflation down without having to slow the economy substantially and allow unemployment to rise materially.
The Fed chair, however, also admitted that he expects this to be "very challenging," adding that there are factors outside of the Fed's control.
To prevent higher inflation from becoming entrenched, Powell said committee members would not hesitate to raise rates even higher than they expect if necessary. "That suggests the Fed is much more focused on inflation than unemployment, and willing to accept a rise in unemployment," Swonk said.
Spillover risks to emerging markets
The Fed's shift to a more aggressive tightening mode could lead to spillover effects on emerging markets, given its important role in the global financial system.
"The Fed is the default central bank to the world. Every time it raises rates, developing economies are pressed to match those moves to defend their currencies and prevent a larger surge in inflation. That makes their debt harder to service," Swonk said.
Lachman noted that as the Fed moves to a tightening cycle and US interest rates become attractive to investors, money will be repatriated from the emerging market economies back to the United States "on a major scale."
"The World Bank is correctly warning that such capital repatriation could result in a wave of debt defaults in the highly indebted emerging market economies," Lachman said.
During the 2022 Spring Meetings of the IMF and the World Bank held two weeks ago, officials and economists already warned about the potential spillover risks of US Fed's more aggressive monetary tightening.
READ MORE: Imports surge pushes US trade deficit to record high in March
It could add pressure to capital outflows in emerging markets, push up imported inflation, increase debt vulnerabilities and reduce policy space, Malhar Nabar, division chief at the IMF's Research Department, told Xinhua in a virtual interview earlier.
"So, there is a concern that emerging market economies that have borrowed heavily in dollars, and especially on short maturity, could find themselves in a difficult position," Nabar said.
"And that would then lead to a slowdown in their economies," he said. "Or if they're not able to meet their debt service obligations, then of course, that would create wider debt problems."
Earlier April, IMF Managing Director Kristalina Georgieva warned that emerging and developing economies face the added risk of "potential spillovers" from monetary tightening in advanced economies – not only higher borrowing costs but also the risk of capital outflows.
To address these challenges, countries should be prepared to use the full set of tools available, ranging from extending debt maturities and using exchange rate flexibility to foreign exchange interventions and capital flow management measures, Georgieva said.