The U.S. Fed’s long shadow on central banks around the world

Over the weekend the American central bank indicated quicker tightening than expected — this makes emerging market economies, especially low-income ones, vulnerable

High inflation has become a headache for the U.S. economy. Its central bank, the most powerful institution of the global economy, was slow to react to growing signs of rising inflation, and it has been under fire for falling behind the curve.

In a much-awaited speech on Friday (August 26) at the yearly U.S. Federal Reserve’s confab at Jackson Hole in Wyoming, its chair Jerome Powell stated its intent in the clearest terms yet since embarking on an aggressive tightening cycle in March to clamp down on inflation, the highest in the country for four decades. The message of the eight-minute-long speech was that U.S. inflation is still too strong for its central bank to breathe easy, dashing hopes of an early softening of rate hikes or a “softish landing”, as Mr. Powell had put it a few weeks ago raising those expectations. The speech sent global financial markets into a fall. Investors who had been underestimating the Fed’s determination to tackle high inflation are now reassessing how much tighter U.S. monetary policy can get, and how much slower the economic growth rate is likely to be consequently.

The Fed has raised benchmark interest rates by 2.25% points this year. Yet, “high inflation has continued to spread through the economy”, said Mr. Powell at Jackson Hole, in a clearly hawkish message. “There is clearly a job to do” to bring inflation back into control, and that the Fed would “keep at it,” he went on. Reducing inflation, he cautioned, would likely require “a sustained period of below-trend growth”. 

The growing risk is that as it plays catch-up with high inflation with aggressive monetary tightening, the Fed will only add to the pain in the global economy. Aggressive interest rate hikes could tip the U.S. economy into full-blown recession (its GDP has already contracted in two consecutive quarters) and global growth into deep slowdown.

Quicker tightening by the Fed will reverberate across the global economy. Global financial conditions could tighten further. Emerging market economies, and especially low-income ones are especially vulnerable. Their sovereign debt will become more expensive. Their fuel and food imports have been made more expensive, as it is, by weakening currencies. The fear is that dwindling foreign exchange reserves could tip many, like Sri Lanka and to some extent Pakistan, into severe debt crises.

In other words, the economic outlook is not great. Inflation is the topmost concern of all economic policymaking now. The thinking is that if policymakers fail to act decisively even now to control inflation, even if by sacrificing growth, the consequences later will be worse, as high inflation could get more deeply entrenched, requiring even larger increases in interest rates, leading to a prolonged slowdown or, worse, recession. And because a lot of the inflation is coming from the supply side that monetary policy tools can barely fix, central banks may have to sacrifice much more growth, deliver much more pain for restoring price stability.

The Fed’s critics, such as former U.S. Treasury Secretary Larry Summers, have long held that if the central bank had reacted sooner, inflationary pressures could have been stamped out with smaller growth sacrifices.