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The Fed admits to being behind the curve. Indeed, the US central bank should tighten its monetary policy aggressively as the labor market is extremely tight and inflation is stronger and more persistent than expected.
The Fed has more good reason to act than the European Central Bank (ECB). Inflation is a global phenomenon, it has increased sharply in the United States and in the euro zone. Nevertheless, the components of inflation are different in these two regions of the world. In the euro zone, inflation is mainly driven by energy prices. In the United States, it is also the result of strong demand. Indeed, the American economy is running at full speed. Companies are increasing their margins: prices are rising faster than their costs. The US labor market is extremely tight and pushing wages to grow at the fastest pace in decades.
The tone of the Fed’s monetary policy committee meeting in March was offensive on many fronts. Federal Reserve Chairman Jerome Powell made clear his determination to do whatever it takes to bring inflation down when he said the committee wanted to slow demand to better align it with supply. and that he was aiming for less accommodative financial terms. As a result, economic projections now show a median terminal rate at 2.75%, above the neutral level of 2.5%. Separately, Powell recently reaffirmed that the Fed is ready to raise the rate by 50 basis points in future meetings, so the neutral level of 2.5% could be reached in late 2022 or early 2023.
Fed rate hikes should slow demand; the question now is what will be the pace of the slowdown in the US economy. It should be borne in mind that so far demand has been supported by a buoyant labor market, accommodative financial conditions and the strong fiscal policy measures taken in response to the coronavirus crisis. The Fed feels comfortable moving forward with its tightening process without putting the US economy in a recession-like environment. In addition to the strength of the US labor market, the short-term vulnerability of the economy to rising interest rates has diminished, thanks to the many safety cushions put in place during the Covid crisis: cash on company balance sheets, household savings… The Fed will be in a more difficult situation in 2023 due to the arbitration between growth and inflation which could prove problematic in the second half of the year.
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