Are storm clouds rising for the global economy?

The US inflation rate inched down in October. Annual consumer price growth slowed to 7.7 per cent, less than the 8 per cent expected by economists, to hit its lowest level since January. The closely followed “core” measure, which strips out volatile food and energy prices and is regarded as the best indicator for inflation’s future trajectory, eased from a four-decade high. Investors increased bets that the Fed would lift interest rates by 0.5 percentage points in December, having raised rates by 0.75 percentage points at its last four meetings. In public remarks, two Fed presidents, Patrick Harker and Lorie Logan, indicated they expect the central bank to begin decelerating the pace of rate increases soon.

However, coming months may not be a smooth ride for US and the global economy. At the heart of the issue are the past mistakes by US Fed. The first big policy mistake was the pandemic era stimulus programs of both the Trump and Biden administrations. Their second mistake was mischaracterizing demand-driven inflation as transitory. The 2021 runup of oil prices was triggered by stimulus inducing more driving and more factory use of oil. Similarly, the huge increase in the prices of used cars was not caused by a sudden collapse of supply; it was simply a lot of people with stimulus checks trying to upgrade their rides. Excessive stimulus was the root cause of the inflation.

Most forecasters are assuming the Fed Funds rate would peak at 5.38% and then could be cut a little in 2024. But forecaster must consider whether the response of inflation to monetary policy will be weaker and slower this time around or stronger and faster. The Fed will face a difficult choice in 2023: get rates high enough and then wait patiently, or keep raising interest rates until the target is achieved. The few dovish voices within the Fed will argue for the first point, and the Fed’s econometric models will support that approach. Panic and concern about political fallout from excessive, ongoing inflation will lead the hawks to support continued rate increases. What is clear, however, is that the Fed’s September 2022 projections will not be enough.