The United States’ economic growth, still racing at an inflationary pace while other key parts of the world slow down, could pose global risks if it forces Federal Reserve officials to raise interest rates higher than currently expected.
The Fed’s aggressive rate increases since last year have the potential to stress the global financial system as the US dollar soars, but the impact has been muted by largely synchronized central bank rate hikes and other actions taken by monetary authorities to prevent widespread dollar funding issues for companies and offset the impact of weakening currencies.
Now Brazil, Chile and China have begun cutting interest rates, with others expected to follow – actions that international officials and central bankers at mid-August conference in Jackson Hole said are largely tuned to expectations that the Fed won’t raise its rate more than an additional quarter percentage point.
While US inflation has fallen and policymakers largely agree that rate hikes are nearing an end, economic growth has remained unexpectedly strong, which could potentially trigger a central bank response – something Fed Chair Jerome Powell noted in remarks on Aug 25.
That sort of policy shock, during US economic divergence with the rest of the world, could have significant ripple effects.
Global divergence
Fed policymakers will deliver a crucial update to their economic outlook at a Sept 19-20 meeting, when they are expected to leave the policy rate unchanged at 5.25 percent to 5.5 percent.
If inflation and labor market data continue showing an easing of price and wage pressures, the current forecast for one more quarter-point increase may hold.
Yet Fed officials remain puzzled and somewhat concerned over conflicting signals in the incoming data.
Some point to weakening in manufacturing, slowing consumer spending and tightening credit, all consistent with the impacts of a strict monetary policy and cooling price pressures.
But gross domestic product is still expanding at a pace well above what Fed officials regard as a non-inflationary growth rate of around 1.8 percent. The US GDP expanded at a 2.4 percent annualized rate in the second quarter, and some estimates put the current quarter’s pace at more than twice that.
The contrast with other key global economies is sharp. The euro area grew at an annualized 0.3 percent in the second quarter, essentially a stalled speed. Difficulties in China,meanwhile, may drag down global growth the longer they fester.
Quizzed about the divergence after a speech, European Central Bank President Christine Lagarde noted that after the Russia-Ukraine conflict broke out last year, the outlook was for a euro-area recession – a potentially deep one in some parts.
Growth, albeit slow, has continued, and inflation has fallen, an overall dynamic not dissimilar to that of the US.
“We expected it to be a lot worse.It has turned out to be much more robust, much more resilient,”Lagarde said.
US fiscal policy is driving some of the difference with $6 trillion in pandemic-era aid still bolstering consumer spending. A recent investment push from the Biden administration is supporting manufacturing and construction.
China may also play a role, economists say. Its slowdown after a short-lived growth burst earlier this year could pinch Germany’s exports and slow Europe’s growth, for instance.
But, Citigroup Chief Economist Nathan Sheets said, “When you hear economists give you three or four reasons for something, that’s usually because we really don’t know.”
Too strong for comfort?
The longer the US economy outperforms, the more Fed officials wonder if they understand what’s happening.
A recent improvement in productivity, for example, could explain how inflation continues falling even as growth remains strong.
Under current Fed thinking, a period of below-trend growth is needed to drive inflation sustainably back to the 2 percent target. Key inflation measures are currently more than twice that.
Most officials do think the economy will slow, as tight policy and stringent credit are more fully felt and pandemic-era savings are spent down. Consumer loan delinquencies are starting to rise and the restart of student loan payments could upend services spending less affected by Fed actions so far.
“There may be a significant further drag in the pipeline,” Powell said on Aug 25, a reason to hold off on further hikes and study how the economy evolves.
But, he added the Fed was “attentive to signs that the economy may not be cooling as expected”, with recent consumer spending “especially robust”, and the housing sector” showing signs of picking back up”.
Any significant surge in home prices or rents would undermine the Fed’s view that easing shelter costs would be key in helping to slow the overall pace of price increases.
While the focus is on inflation data, topline economic growth that remains above trend could undermine faith that inflation will fall and increase concerns that it might rise- an outcome Fed officials view as particularly pernicious and have pledged to avoid.
“Evidence of persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy,” Powell said.
Source: Reuters
