Fed's outsized rate hike may be a recipe for recession
We are in the middle of the Great Tightening with global central banks engaging in a bare-knuckle fight with the inflation monster. On Wednesday, the US Federal Reserve joined forces, although belatedly, with a 75 bps policy rate hike, while the European Central Bank summoned an emergency meeting and will likely increase rates next month - its first in 11 years.
The question isn't if such coordinated and aggressive policy tightening to attack inflation will succeed, but whether it can do so without causing further trouble, particularly in developed nations, which indulged in an unprecedented fiscal stimulus over the past two years.
For instance, in the US, the Fed's outsized rate hikes just when the economy is slowing down are feared to be a recipe for a recession. No central bank confirms the possibility of an incoming recession, so the Fed chief Jerome Powell coined a new term 'softish landing', but few believe in such an outcome.
Several estimates peg 2023–2024 to be a recession year for the world's largest economy, even though the Fed's growth forecasts were simply cut to 1.7 per cent in 2022 and 2023, from 2.8 per cent and 2.2 per cent, respectively.
In Europe, besides slowdown fears, concerns are rising over widening bond yields among eurozone countries threatening a sovereign debt crisis, which nearly ruined it just a decade ago. Any similar financial turmoil will be fatal for the rest of the world, too.
Meanwhile, the Fed’s rate guidance suggested the July hike could be either 75 bps or 50 bps, which is a significant departure from its norm of 25 bps increments. Put another way, Wednesday's action was the Fed’s way of making up for the lost ground.
This is exactly what the Reserve Bank of India wanted to avoid and acted just in time raising rates last month. But the larger issue is how long the tightening cycle will last.
Worryingly, the Fed expects its policy rate to be anchored at 3.5 per cent by 2022, a full 1.5 per cent higher than its March estimates. While RBI gave no such clarity, interest rates shouldn’t be too steep and avoid stifling growth recovery.