Fed should postpone the next rate hikes

By Karl Smith

The US Federal Reserve is widely expected to raise interest rates by at least 25 basis points next week. And if inflation remains high, the Fed is “prepared to raise it higher than that” in the coming months, central bank Chairman Jerome Powell said last week.

That would be a mistake. After next week’s hike, the Fed should pause for at least the next few months and possibly into the summer, even though the war in Ukraine will undoubtedly worsen US inflation.

It is unclear how serious the conflict will be, what effect it will have on the region, or whether it will lead to a global recession this year. The probability of it happening last is less than the most extreme predictions, but it is real nonetheless.

A more aggressive Fed could use a recession as an opportunity to quickly reduce inflation by sticking to its rate-hike schedule. That is a risky policy and one that Powell seems unwilling to take. If a recession hits, the Fed will likely simply have to reverse the rate hikes it has made in previous months.

An oscillating pattern in rates would weaken the overall impact of Fed policy. Consider, for example, the plight of a homebuilder who cuts production next summer in response to rising rates.

You’re not likely to increase output immediately if rates fall in December, but you’ll want to wait for a sign that rates will stay low for a while. From the Fed’s perspective, it would be more effective to leave rates alone and encourage keeping output high for the next several months.

There are also risks to consider beyond the full recession. The direct costs of rising energy and food prices will reduce consumer savings. More importantly, rising commodity prices are likely to dent consumer confidence leading to reduced spending on other items.

Another consideration is the effect of the war on developing markets around the world. Higher food and energy prices will hit their economies harder. Global uncertainty will lead investors to move funds out of their markets and into the United States. That could cause a drop in demand for US exports, which are geared toward investment goods like heavy machinery. That would reproduce some of the effects of the mini-recession that hit the Midwest in 2015 and 2016.

At the same time, money flowing into the United States from developing markets and Western Europe will push the dollar higher and the relative prices of imports lower. As consumer spending shifts toward imports, that will cool some of the underlying inflationary pressures in the United States.

The short-term environment is complex. It is unclear how long the war will last and how far-reaching its effects will be. Yet the Fed’s ideal response is simple: go ahead with next week’s rate hike. But he must make it clear that there will be no more for at least the next two meetings, and then only when there is more certainty about the consequences of the war in Ukraine.