The United States economy is suffering from high inflation. To control it, the Federal Reserve moved aggressively to raise interest rates, with the target range for federal funds up by a hefty 75 basis points, the sharpest hike since 1994. Given that inflation in the American economy is persistent and structural, it is almost impossible to counter inflationary pressure with aggressive interest rate hikes and also avoid slamming the brakes on the economy. The world needs to prepare for new shocks.
U.S. inflation has been running at more than 5 percent for 12 months and 8 percent for three consecutive months. It surged to 8.6 percent in May, its highest in more than 40 years. In fact, the ongoing inflation is broad-based, with housing, gasoline and food contributing the most. Energy prices rose 34.6 percent in May from a year earlier, the highest since September 2005, and food prices rose 10.1 percent year-on-year, the highest since March 1981. High inflation erodes consumer purchasing power and economic growth, and the Fed has made fighting inflation its top priority.
But raising interest rates is a double-edged sword. With economic momentum running out of steam, higher interest rates and monetary tightening will have a big impact. As interest rates rise and the impact is felt at different layers of finance, the cost of borrowing — including mortgage debt and commercial loans — will rise, which will hit the real estate sector, cut consumer spending and chill business expansion, thus weakening the labor market and growth prospects. Recently, the U.S. economic sentiment indicator and misery index have both shown signs of recession.
First, consumer confidence is at its lowest level in more than four decades, as reflected in the plummeting consumer confidence index, in the face of persistent inflation. The University of Michigan consumer confidence index fell to 50.2 in June, down 8.2 percent from May. It was the lowest in 44 years, even below 2020 during the COVID-19 pandemic and 2008 during the Lehman Brothers crisis. Given that American economic growth is mainly consumption-driven, low consumer confidence signals pessimism about growth.
Second, the misery index is at its highest since World War II. The index is the sum of the unemployment rate and the inflation rate. It was created in the 1970s by Arthur Okun, a professor of economics at Yale University, as a measure of the economic well-being of ordinary people. The higher the index, the greater the economic misery.
The unemployment rate was 3.6 percent in May, which is pretty low historically. However, the concern that high inflation will lead to recession will affect the job market and have a negative impact on corporate hiring. In June, the U.S. employment market showed a low trend in unemployment benefit claims but a clear increase of initial claims. Pressure on the job market will become more apparent as time goes by. The misery index has already soared to 12.2, higher by historical standards than that of any of the post-WWII recessions.
Third, the housing market, which had been a driver of growth, has also seen a significant ebb. The index of homebuilder confidence fell two points to 67 in June, its lowest level since June 2020 and the sixth straight monthly decline. As treasury yields continue to rise, 30-year mortgage rates have risen by 2 percentage points, returning to the level last seen more than a decade ago. In the most interest-sensitive sector, a surge in mortgage rates will dampen buying demand, bringing prices down and thus impacting the property market.
Throughout the history of America’s fight against inflation, recession is the inevitable price. From 1979 to 1982, Paul Volcker, who was chairman of the Fed, made a resolute decision to fight inflation with sharp interest rate hikes. In the process, the public came to appreciate the Fed’s determination to control inflation. Inflation expectations were eventually reversed and inflation was gradually brought down to around 5 percent, but Volcker’s epic battle against inflation also led to the worst recession since the Great Depression of the 1930s and a 10 percent unemployment rate.
When Volcker was in office, monetary tightening sent the federal funds rate soaring to a peak of 20 percent. The current target range for the rate is between 0.75 and 1 percent, which means a very long journey ahead on the path of raising rates and tightening. This round of inflation has been stubborn and structural. It is almost impossible to bring core inflation down to 2 percent without tipping the economy into recession. The U.S. economy will inevitably experience a Volcker-style contraction.
As the U.S. is the world’s largest economy and the U.S. dollar is the world’s main settlement currency, the Fed moving into an interest rate raising cycle will obviously bring multiple risks to the global economy. Many economies have followed suit in raising interest rates. According to a BofA Global Research report, some central banks have cumulatively raised interest rates 124 times this year, more than the total in 2021. They did so only six times in 2020. Continued cumulative monetary tightening will lead to a sharp tightening of global financial conditions. Downward pressure from high inflation and monetary tightening, plus higher replacement costs due to the reversal of globalization and the restructuring of supply chains, could drive up the risk of stagflation for the whole world.