What if US interest rates rise further and have to stay high for longer? – 02/22/2023 – Solange Srour

Last week, Fed chairman Jerome Powell said the path to reducing US inflation this year “is likely to come and go.” Such an indication became even more likely after the release of new data showing that the US economy is not slowing down as expected, while pressures on prices are more persistent – mainly in services, which are intensive in labor.

If before the discussion was whether the economy would go through a “soft landing” (soft landing) or a “hard landing” (recession), now it comes to discussing the “no landing” (scenario in which activity remains strong). If, on the one hand, both the Fed and the market are more confident that a further slowdown in activity will be avoided in the short term, on the other hand, the battle against high inflation seems far from over. One of the consumer inflation data for January shows a core (inflation ex-food and energy) close to 4.5% — well above the 2% target.

The rate at which inflation has fallen so far is not giving the Fed confidence that the target will be met. Having already raised interest rates from near zero to the 4.5% to 4.75% range, the Fed will likely need to tighten monetary policy further or keep it tighter for longer than it assumed would be enough to cool down the US economy.

Some economists already predict that the Fed will raise its forecast for the future path of interest rates at its next meeting in March, although the additional employment and inflation data that will be released by then will be key to that decision.

In December, the Fed indicated that the so-called “terminal rate” would be between 5% and 5.25% this year, which would imply only two additional interest rate increases of 0.25 percentage points in 2023. the Fed is aiming for another hike at the June meeting. A few economists even consider that the US monetary authority could raise interest rates again by 0.25 percentage points in March, which would result in a much higher estimate for the terminal rate than the current one.

We know that there are lags in monetary policy transmission —the impact of a tightening of interest rates materializes over time—, which leads central banks in general to interrupt the process of raising interest rates when their projections point to the achievement of the inflation target within its scope of action, not when inflation itself reaches the target. That said, the fact that recent activity data are positively surprising, especially those referring to the labor market, raises questions about the possibility that some factors are operating to make the transmission of monetary policy appear slower or insufficient.

First, although credit conditions are tighter, the health of corporate balance sheets limits the immediate impact of this channel. A decline in corporate earnings would be a powerful disinflationary force, but the recent upward revisions to these forecasts suggest that the effect of this factor will be more limited than usual in the current phase of the currency cycle.

Second, the neutral interest rate —one that is neither inflationary nor disinflationary—may have risen in the US. In the aftermath of the pandemic shock, fiscal policy became much more expansionist, bringing a significant increase in public debt.

Finally, the leverage of companies and families is now much lower than it was before the great financial crisis, which reduces the impact of the credit crunch on the activity as a whole.

Brazil will certainly be affected if American interest rates remain higher and for a longer period of time at a restrictive level. The decrease in our interest rate differential will reduce the attractiveness of domestic assets, even more so at a time when the country is putting its fiscal and monetary anchors at risk. The exchange rate will tend to depreciate against the dollar, with important effects on the dynamics of inflation.

Furthermore, the greater resilience of growth and the greater persistence of inflation are a reality in other economies, not just the US, which increases the pressure for further global monetary tightening, bringing the risk of a deeper, more synchronized slowdown. There is no intense discussion in the world about raising inflation targets, despite the fact that most countries have inflation far from their targets.

It seems to be imprudent to rely on a favorable external scenario to postpone urgent adjustments in the domestic economic agenda or retreat from past achievements.

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