U.S. economic growth, which is still moving at a potentially inflationary pace while other parts of the world are slowing down, could create global risks if it compels Federal Reserve officials to raise interest rates higher than anticipated. Last year, the Fed’s aggressive rate increases had the potential to strain the global financial system due to the soaring U.S. dollar. However, the impact was mitigated by synchronized central bank rate hikes and other measures taken by monetary authorities to prevent widespread dollar funding issues and counter the effects of weakening currencies.
Currently, Brazil, Chile, and China have started cutting interest rates, and it is expected that other countries will follow suit. International officials and central bankers at the recent Jackson Hole conference stated that these actions are largely based on the expectation that the Fed will not raise its rate by more than an additional quarter percentage point. While U.S. inflation has decreased and policymakers generally agree that they are nearing the end of rate hikes, economic growth has remained unexpectedly strong. Fed Chair Jerome Powell acknowledged that this could potentially lead to a stall in progress on inflation and trigger a response from the central bank.
This type of policy shock, occurring at a time when the U.S. economy is diverging from the rest of the world, could have significant ripple effects. International Monetary Fund chief economist Pierre-Olivier Gourinchas warned that if the need arises for more action than what is already anticipated, markets may become nervous, resulting in a sharp increase in risk premia across various asset classes, including emerging markets.
According to Cleveland Fed President Loretta Mester, it is normal for policies to diverge after the shock of the pandemic and the subsequent inflationary rebound that led most countries to raise rates together. However, the Fed’s actions carry significant weight due to the interconnectedness of the global economy. Mester emphasized that if the Fed can achieve a timely and sustainable return to 2% inflation, along with a strong labor market, it would benefit the global economy.
Fed policymakers will provide a crucial update on their economic outlook at a meeting in September. If inflation and labor market data continue to show a decrease in price and wage pressures, the current forecast of only one more quarter-point increase in rates may hold. However, Fed officials remain puzzled and somewhat concerned about conflicting signals in the incoming data. While some indicators point to weakening manufacturing, slowing consumer spending, and tightening credit, which are consistent with the impact of strict monetary policy, gross domestic product (GDP) is still expanding at a pace well above the non-inflationary growth rate. In contrast, other key global economies, such as the euro area, are experiencing slower growth.
European Central Bank President Christine Lagarde noted that the euro area’s performance has been more robust and resilient than expected, similar to the U.S. situation. The difference in performance can be attributed to U.S. fiscal policy, with significant pandemic-era aid supporting consumer spending, as well as recent investment initiatives from the Biden administration. Additionally, China’s slowdown could affect Germany’s exports and slow down Europe’s growth.
The longer the U.S. economy continues to outperform, the more Fed officials question their understanding of the situation. Recent improvements in productivity may explain why inflation continues to fall despite strong growth. According to current Fed thinking, a period of below-trend growth is necessary to sustainably bring inflation back to the 2% target. While most officials anticipate a slowdown in the economy due to tight policy and stringent credit, there are concerns about rising consumer loan delinquencies and the potential impact of student loan payments restarting.
Fed Chair Jerome Powell acknowledged that there may be significant drag in the pipeline, which is a reason to hold off on further rate hikes and closely monitor the evolution of the economy. However, he also highlighted the robustness of recent consumer spending and signs of recovery in the housing sector. Any significant surge in home prices or rents could undermine the Fed’s view that easing shelter costs would help slow overall price increases.
While the focus is on inflation data, sustained above-trend economic growth could jeopardize progress on inflation and potentially warrant further tightening of monetary policy. This is a moment that other countries need to be prepared for, as the risk of U.S. disinflation has not yet materialized, according to IMF chief economist Pierre-Olivier Gourinchas.
In conclusion, the article highlights the potential risks posed by U.S. economic growth and the need for the Federal Reserve to carefully manage interest rates. The divergence between the U.S. and other global economies, along with conflicting signals in the data, adds to the uncertainty. The article emphasizes the interconnectedness of the global economy and the importance of the Fed’s actions in shaping the overall economic outlook.
