The Fed should be wary of sharp interest hikes

The Federal Reserve Building, DC. Credit: AgnosticPreachersKid (Via Wikimedia Commons).

The US economy is slowing down from the high growth rates seen in 2021. This slowdown is not surprising, given the pandemic and the policy response. Nevertheless, this news has been largely met with a grim reaction from market participants. Just to take an example, JP Morgan's influential podcast Notes on the Week Ahead used words such as "unfortunate," "bleak," and "squeeze" to describe a decrease in GDP.

As per the traditional technical definition of a recession, two consecutive quarters of decline in GDP would mean that we are officially in a recession. However, as with any other rule of thumb, this does not accurately account for all of the nuanced factors involved in assessing the state of the business cycle.

With many economics heavy-weights like Lawrence H Summers - former Treasury Secretary and President Emeritus at Harvard - noting that Friday's GDP report "does not suggest we are currently in recession," it is evident that the question about whether we are indeed in a recession or not is still very much under debate.

Whatever the case may be, the fact remains that a general slowdown is necessary to bring inflation down to the Federal Reserve's target of 2%. The Fed's overspending during the pandemic, supply chain issues, and strong demand due to unexpectedly fast recovery from the pandemic are all behind the current inflation regime we are experiencing.

A recent economic study showed that supply factors are responsible for more than half of the current elevated level of 12-month PCE inflation. Given this, steep interest rate hikes to combat inflation run the risk of overcorrecting the inflation and could bring about a recession. As the pent-up demand naturally subsides and supply chain issues are corrected, it seems reasonable to expect inflationary pressures to diminish independently without painful intervention from the Fed.

The Federal Reserve, for its part, hasn't yet raised interest rates to levels that would guarantee a hard landing. But with the increasing panic about inflation and an accompanying recession, the Fed might decide to adopt a more aggressive policy. Such an aggressive policy could precipitate a harrowingly hard landing with disastrous consequences.