The Fed is ready to aggressively combat inflation

The U.S. Federal Reserve says it will be aggressive in its efforts to combat inflation, even if that means moving past a neutral stance with its monetary policy. At its mid-March meeting, the Federal Open Market Committee (FOMC) voted to increase the benchmark federal funds rate by 25 basis points, to a range between 0.25% and 0.5%.¹ It was the first rate increase by the Fed in three years. The Fed also announced it will likely raise rates six more times this year.

At an economic conference after the meeting, Fed Chair Jerome Powell said the U.S. central bank is prepared to raise rates even more aggressively if doing so will be necessary to bring down inflation, which has reached levels not seen in four decades.²

In a report to Congress, the Fed also acknowledged that the high level of inflation, which had initially been concentrated with the prices of goods, has broadened into services.³ The higher prices for services have been driven, the Fed noted, by strong wage growth and a significant increase in rents, which service providers have passed through to their customers.

Even though the Fed has not raised rates at an increment of 50 basis points or more since 2000, some analysts expect the Fed could make 50-basis point hikes at both the May and June FOMC meetings.

Chair Powell indicated the Fed would be willing, if high inflation persisted, to eventually push past a neutral rate (one that neither boosts growth nor dampens demand), which it estimates is a federal funds rate of 2.4%.

Powell said he believes the Fed could achieve a balance between lowering inflation and avoiding the adverse effects on the economy of higher rates, but he admitted finding that balance will be a challenge given the economic impact of Russia’s invasion of Ukraine.

Inflation hits 40-year high

The Consumer Price Index in February was 7.9% higher than it was a year ago, reaching a level not seen since January 1982, according to the U.S. Bureau of Labor Statistics.⁴ Food and energy prices, which have been soaring in reaction to Russia’s invasion of Ukraine, were key contributors to the increase.

The core inflation rate, which excludes volatile food and energy prices, was 6.4%. That too was a level not seen since 1982. Still, evidence that the pace of inflation might be tapering for other goods and services came from the producer price index (PPI) in February. Excluding food, energy and trade services, the core PPI increased by only 0.2% for the month, well below the 0.6% rise many had expected.⁵

Gauging the impact of the war in Ukraine

Time will tell how much Russia’s invasion of Ukraine and the resulting sanctions against Russia impact the global economy. Russia has been a key supplier of energy, and both countries are major suppliers of food, particularly wheat.

Economic forecasters regularly surveyed by CNBC pared back their expectations for U.S. growth in the second quarter by 0.8 percentage points, given the economic fallout from the war.⁶ Still, they believe growth could increase by 3.5% in the second quarter, as the economy continues its rebound from the omicron wave, even while coping with the effects of high inflation.

Analysts expect that Europe will be hit much harder. As CNBC reported, Barclays reduced its forecast for European growth in 2022 from 4.1% to 3.5%. With Europe so dependent on Russia as an energy supplier and the war occurring on its border, the continent is likely to bear much more of the brunt of soaring commodity prices and investors’ risk aversion in times of crisis.

President Biden’s budget proposal includes a record tax hike

On March 28, President Joe Biden put forth a $5.8-trillion budget proposal for 2023 that emphasizes budget reduction as well as more funding for police and veterans.⁷ While Congress rarely follows the specifics of the executive branch’s budget recommendations, a President’s budget can influence the agenda and set priorities for the budgetary process in the House and Senate.

The Biden budget request includes a record tax hike. It calls for more than $2.5 trillion in tax increases over a 10-year period on the wealthy and large corporations. It would add a 20% minimum tax on the unrealized capital gains of households worth at least $100 million. Several of the tax proposals, such as raising the corporate tax rate from 21% to 28% and increasing the highest individual income tax bracket to 39.6%, seem to have a slim chance of passing. Moderate Democratic Senator Kyrsten Sinema of Arizona, whose vote will be critical for any budget proposals to be approved by the Senate, has already said she could not support those tax rate increases.⁷

More disruptions for global supply chain

Supply chain bottlenecks were a major disruptive force for the global economy in 2021. Many had expected those issues would begin to resolve themselves this year, but the war in Ukraine and a new coronavirus outbreak in China make it appear that problems with the global supply chain could persist for much of this year.

Financial sanctions and the close of Russian airspace are causing cargo planes, as The Washington Post notes, to fly longer, costlier journeys from Asia to Europe. Dozens of Chinese factories and warehouses have been closed, as China experiences its worst outbreak of the COVID-19 virus since the original wave in Wuhan.⁸

On March 14, the local government in Shenzhen imposed what ended up being a weeklong citywide lockdown, as it attempted to stem the rise of COVID-19 cases and block the virus’s spread into neighboring Hong Kong, where cases have also been increasing since January.⁹ Shenzhen is home to half of all China’s retail exporters and is also a center for consumer electronics makers, including Apple’s largest supplier, Foxconn. Some manufacturers in Shenzhen have been allowed to reopen while operating under tight restrictions.¹⁰

New strain of the virus in Northeast U.S.

A new strain of COVID-19 – the omicron BA.2 subvariant – has been hitting the New England and New York region. While the number of new cases has been declining across the United States, New York saw a 33% increase in cases for the week ending March 19.¹² The BA.2 variant has caused half of the new infections there. While this new variant isn’t viewed as more dangerous than previous ones, it does appear to be more infectious. Many will be watching to see if the trend matches what was seen in the United Kingdom, which experienced a rise in cases in February, as BA.2 accounted for half of the new infections.

The BA.2 outbreak remains far below levels seen with the previous omicron variant. Still, it’s a trend that will have to be monitored, both for its obvious health implications and its economic impact.

A potential rebound

Financial markets may have hit a trough, having priced in highly negative sentiments. If the Fed delivers on its goal of curbing inflation with rate hikes and if Russia agrees to a ceasefire, the equity market could be poised for a rebound.

Tags: Geopolitical, Inflation, Interest rates