Suddenly, the global inflation/recession debate has become two-sided. For much of 2022, the mantra on the street was that central banks around the world need to raise interest rates aggressively in such a manner that alarmingly high levels of observed inflation do not feed into inflation expectations. Higher inflation expectations that hold for an extended period have a nasty habit of becoming entrenched, with a disproportionate impact, particularly on those who are not well off. Slow off the block in its fight against price-instability, the US Federal Reserve has raised interest rates in the US eight times since March 2022, from around 0% to 4.5% now. It is widely expected to raise rates at least twice more to about 5%. The Fed uses the federal funds rate as its policy mechanism; this is the target interest rate set by the US Federal Open Market Committee (FOMC) for overnight loans between banks.
The probability of an increase in the fed funds rate is easy to observe directly as the yield on the 30-day Fed funds futures contract. As of today, this metric suggests a 91% probability that the Fed will raise rates by 25 basis points (0.25%) on 22 March and an 82% probability that it will raise by another 25 basis points on 3 May. After that point, current readings suggest a 60% probability that the Fed will either hold or cut rates.
Against this backdrop of slowing interest rate increases and declining inflation (year-on-year consumer price index inflation peaked in the US in June 2022 at 9.1%), the US recently reported a surprising and large 517,000 addition to jobs. The Fed’s rhetoric has shifted from a broad attack on inflation to a more targeted one on cooling the American labour market.
This confusing set of signals has produced a spirited debate between those who say that the Fed “needs to do more” and others who argue “it might overdo it”. Overdoing in this context implies increasing the probability of a recession. The Fed uses a “dynamic factor Markov switching model” to predict the risk of a recession. That model is indicating a mere 5% chance of a recession. As Bill Dudley, former president of the New York Fed put it, “The [US] Fed has engineered a recession 100% of the time that it has targeted an overheated labour market.” Meanwhile, the yield on the US 10-year bond is lower than that on the 2-year bond . This type of inversion has always preceded a US recession, but not every inversion has led to a recession.
Economists of every persuasion have begun to quarrel with how to read these numbers. Inflation hawks point to the strong labour market demand and say that unless it cools further, there should be no question of the Fed stopping its rate increases. Prominent in this group of economists is Larry Summers who warns that the Fed should not relax too early and must continue to “administer medicine until the infection is well and truly gone”.
Another school has it that while the US labour market is indeed strong, the recent number will be revised downward. Monetary policy functions with a lag, and, according to this group, job additions will drop from a trend of over 200,000 jobs a month to less than a 100,000. Over-reading an individual month of data would needlessly risk recession. Nobel Laureate Joseph Stiglitz believes that this supply-chain-led inflation scare will be exacerbated by the Fed raising rates “too-high, too-fast, too-far”.
The argument from the monetarist quarter suggests that since the broad measure of money growth (M2) in the US has been going down sharply and has now entered negative territory on an annual basis, inflation will fall sharply. This group believes that the combination of negative money growth, also called quantitative tightening (QT), and interest rate increases implies a 6.5% increase in rates, which should be more than enough to rein in inflation.
Yet another group has switched from being hawkish on inflation to being worried primarily about recession and the Fed overdoing it. Raghuram Rajan and others believe that inflation is coming down because snags in supply chains are being sorted out and demand for home purchases and housing construction have come down. He remains sanguine that even if there is a recession, the Fed should be able to engineer an exit by cutting rates at that time.
From the point of view of emerging markets, including India, this is not some esoteric debate. The relative central bank rate of interest and consequently the evolving relative rate of inflation will determine the path of these countries’ balance of payments and exchange rates. If the currency falls too far too fast, then the country will be subject to imported inflation. Particularly vulnerable are countries with large budget and current account deficits and those that remain dependent on importing crude oil. For capital markets, the higher the US interest rate, the lower the global flows from hard currency into emerging markets.
On the other side, a US recession would also affect a country like India. If technology spending in the US and the import capacity of overseas markets reduce, then that has a direct bearing on India’s services and goods exports, which in turn puts pressure on the current account.
As Raghuram Rajan says, the Syclla of doing too little (inflation) and the Charybdis of doing too much (recession) makes this navigation very tricky from here on.
P.S.: “How prone to doubt, how cautious are the wise,” said Homer, author of the Odyssey, the epic in which appear the twin dangers of Scylla and Charybdis.
Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand