Price increases, interest rates, demand shock… After the central bank’s rate hike by 75 bps, the main question will be whether the interest rates, which will continue to rise, will reduce inflation. As of May 2022, annual inflation in the US is 8.6%, and it is seen that Americans who spend on savings will have less room for consumption as a result of incomes not keeping up with price increases. Considering that the effects of inflation leading to the consumption shock, together with the deteriorated expectation channel, create a serious demand asymmetry, there is a risk of a hard decline in demand in the future. It has become a very probable scenario that the sharp decline in demand will be experienced before inflation, due to the rapidly increasing interest rates.
Monetary policy action plan… The margin of action left by Powell’s statements shows that the Fed will act according to the situation in the bands it will determine while increasing the interest rates. Combined with the economic projections, we can divide the Fed’s actions into two phases: the contingency plan and the progress towards balance targets in the medium term.
The first stage, of course, includes more proactive moves against inflation. Now that the Fed has got rid of its delusion that inflation is temporary, it can make its plan according to inflation, which remains high and carries the risk of spiraling. These effects must tend towards eliminating the distorting effect of inflation in the expectation and demand channel. However, even if these effects are cleared, inflation will remain high for a while and will keep its decline slow despite the rate hikes, if there will be a decrease. This has worsened the supply chain problems inherited from the epidemic, the Ukraine crisis and the increasing Covid cases in China. because it is. We are yet to receive a signal of improvement in supply-related problems.
In the second stage, general assumptions are made according to an environment in which the balances will be both cyclical and normalized thanks to policy adjustments. Core inflation is currently at 6%. In the Fed’s projections, there is a PCE inflation projected to decline to 2.3% on a core basis towards 2024. Although the Fed remains above the target, it expects a reduced inflation outlook in line with the target path as of 2023 and 2024. When we look at the Fed’s federal funding rate projections in this period, it is expected that the interest band, which is currently 1.50 – 1.75%, will be increased to 3.5% towards the end of the year, while a slower rate hike momentum is expected next year and a easing after 2024.
The risk of recession… The Fed’s role model for monetary tightening policy and the fact that countries are not able to avoid raising interest rates in an environment where the concerns of not being able to get rid of the effects of inflation can be felt through the decreasing economic activity, demand and increasing unemployment rate. Regarding the recession, we were talking about regional effects in the previous period. For Europe, like the production effect of the absence of Russian energy in the industry, or the Asian effect of the increasing Covid cases in China. Since bitter prescription programs against inflation are also involved, there will be an unpopular monetary tightening among households and a market that will tighten with the increase in the cost of borrowing. Of course, central banks cannot maintain levels above this natural interest rate, because the threshold to bear high interest rates is limited in terms of rate and time, due to the financial system burden and central government borrowing requirements.
Conclusion? There is a cyclical environment in which central banks must be patient and planned to see the final results, and at the same time avoid overloading policies to compensate for the threshold they missed. If a patient who is using drug therapy against his disease misses the dose he should take, taking a double dose in the next time to make up for it will do more harm than good. Thus, a situation arises where tactical errors and past misreadings will probably not yield very positive results for the overall activity of the economy. The latest economic data released show that the probability of a soft landing is decreasing.
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