Last week, stocks in the United States plummeted after inflation data came in higher-than-expected, sparking fears of a hefty interest rate hike.
To understand why the market reacted so sharply, even though the inflation rate eased for a second straight month to 8.3% in August, you have to go back eighteen months.
In 2021, the US inflation rate started accelerating after a period of meagre inflation during the 2020 lockdowns.
Between January 2021 and July 2021, the US inflation rate increased from 1.3% to 5.4%.
The sudden rise in inflation elicited very different responses from politicians, economists, and investors.
President Joe Biden tried to dismiss concerns, saying, “our experts believe, and the data shows, that most of the price increases we’ve seen were expected and are expected to be temporary”.
Federal Reserve (Fed) chairman Jerome Powell also suggested that the increases in inflation were transitory and merely a temporary imbalance in supply and demand.
“We should look at this as temporary, and we very much think it is,” Powell said.
However, many others suggested that Biden and Powell were misguided and that the higher inflation was not transitory.
Economist Mohamed El-Erian said in October 2021 that inflation was not temporary and that the Fed should move quickly to prevent it from worsening.
In December 2021, Powell admitted that inflation has proven not to be transitory after the November 2021 inflation rate increased to 6.8% – the highest in 40 years.
The Fed waited until March 2022, after inflation hit 7.9%, before they first started increasing interest rates.
Many experts, including former US Treasury Secretary Steven Mnuchin, said the Fed waited too long to control inflation.
The US inflation rate decreased from its 9.1% peak in June to 8.3% in August, showing slight relief from the increasing inflation trend.
However, the Fed has not shown any sign of easing interest rate hikes. In fact, it is expected to increase rates by an additional 0.75% in September.
The biggest concern associated with aggressive interest rate hikes is that it would result in a recession.
The definition of a recession is when there are two consecutive periods of negative GDP growth.
According to this definition, the United States is already in a recession after experiencing two consecutive quarters of negative GDP growth, as shown below.
Many economists argued that the current definition of a recession is too narrow and doesn’t account for the labour market condition.
They say that the low unemployment levels in the US don’t warrant a recession as recessions are paired with increased levels of unemployment.
Others, like former Morgan Stanley Asia chairman Stephen Roach, believe it would take a miracle for the US to avoid a recession.
He stated that until the real federal funds rate – i.e. the nominal interest rate minus the inflation rate – becomes positive, monetary policy is still expansionary.
He suggested that interest rates would need to be increased significantly before the US economy contracted.
Roach added that the United States would need to go through a recession as a lagged consequence of such an aggressive monetary tightening.
When asked about the strong labour market, Roach explained that it is to be expected as the effects on the labour market would only be experienced later in the cycle.
The fact that no impact has been seen on the unemployment rate only shows how much more monetary tightening would be necessary.
The employment rate is known to be a lagging indicator of the economic condition due to the costs of employing and laying off workers.
The latest recorded US unemployment rate was 3.7%, higher than the expected 3.5%. This increase may be the beginning of a painful unemployment cycle.