US Federal Reserve’s policy actions ushering in a slowdown, recession not so likely

Though it is more or less certain that there is going to be a slowdown in growth, there is no indication that the economy may end up in a serious recession.

In June the retail prices in the US rose by 9.10%, the highest level in almost four decades. This rise is despite the last three hikes in the base rate. Therefore, the objective of countering the rising inflation, and bringing it back to the Fed’s target level of 2% remains uppermost in the Fed’s mind. It was expected that the Fed would stick to its aggressive policy stance. The FOMC hiked the base rate by 75 basis points to 2.25%, that is a target range of 2.25% to 2.50%, in its meeting that concluded on July 27, in pursuit of the same objectives.

The Fed statement reads like this, “recent indicators of spending and production have softened. Nonetheless, job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.” It also points out to the impact of the Russian invasion of Ukraine as a factor that is continuing to put upward pressure on inflation and adversely affecting the global economic activity. Apart from hiking the rate, Fed has reaffirmed its commitment to reduce its holdings of government debt and mortgage-backed securities. This is a liquidity normalization act.

It is interesting to note that though inflation has surged, some critical numbers are still somewhere close to the pre-pandemic levels and have not shown incremental growth. This would require careful calibration of policy to ensure that growth is not affected too much by an aggressive interest rate policy. The current stance of the policy both from the rate angle and the liquidity perspective is hawkish, and the choice of the level of trade off between growth and inflation would ultimately determine the trajectory of interest rate movements. Though it is more or less certain that there is going to be a slowdown in growth, there is no indication that the economy may end up in a serious recession.  As the old adage goes, a cat that catches mice may at times break some pots too.

The recent numbers of US GDP growth for Q2 shows a fall of 0.90%, as against a decline of 1.60% in Q1. This fall comes at a time when the fears of a slowdown in economic activity has gripped the markets. While a recession is unlikely, a slowdown seems to be gradually unfolding.

The markets would be looking forward to two things – (a) rate of inflation and the inflationary expectations to see whether the Fed would start moderating its approach to rate action, and (b) the quantum of the future rate hikes, whether it is going to be higher or lower. It is quite clear that there will be more rate hikes in future and the Fed Funds Rate may be set to touch 3.50%, and any moderation in yields seen today may be transient as the liquidity normalization process is still on.

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