Can US Federal Reserve Tame Inflation Without Leaving Recession Scar?

Keeping the key funds rate at a 22-year high, unchanged at 5.25-5.5%, the US Federal Reserve has maintained its strong commitment to achieving an inflation target of 2%. US inflation remains elevated, and the Fed has acknowledged it which is why the central bank signalled for an additional rate hike possibility before the year's end. Every move and rate outcome is aimed at bringing down the stubbornly high consumer price index. However, it seems like the Fed is in a dilemma between managing inflation in a rising energy environment and playing its bet rightly to avoid leaving a recession scar on the economy.

On Wednesday, FOMC's statement said, "The Committee seeks to achieve maximum employment and inflation at the rate of 2 per cent over the longer run. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 per cent."

FOMC highlighted that the recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low. However, inflation remains elevated.

While keeping the key rates steady, FOMC has already signalled that the borrowing costs are likely to stay higher for a longer period and that it estimates an additional 25 basis points (bps) rate hike before the end of the year to tame inflation.

The probability of a rate hike ahead is definitely on the cards.

Naresh Tejwani, Abans Group said, "US FED's decision to defer rate hike, although expected... may keep global markets on tenterhooks. Inflation in the US is as yet high and other economic parameters are still showing little signs of slowing down. The US 10 year at 4.472% and 2 years at 5.184% does reflect the expectation that before year-end further rate hikes may be expected."

FOMC sees the US banking system as sound and resilient, however, it also highlighted that tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation ahead. The quantum of impact of such remains uncertain though FOMC is highly attentive to inflation risks.

Manish Chowdhury, Head of Research, StoxBox mentioned that the FOMC meeting yesterday was picture-perfect, with the Federal Reserve keeping interest rates unchanged and leaving the door ajar for one more hike before the end of this year.

Chowdhury added, "With the call getting louder amongst Fed policymakers to keep rates steady going forward, our sense is that the Fed is in a conundrum over managing inflation in a rising energy environment without leaving a scar of recession on the world's largest economy."

As per the StoxBox expert, the US economy has been defying most of the economic sense and the Fed also acknowledges the same, as reflected from their multi-dimensional approach (inflation, economic growth, labour market, etc.) than the one-dimensional approach (targeting just inflation) followed a year earlier.

"With some recent economic indicators showing a lag effect of the previous rate hikes, we would closely watch the triggers that may prompt the Fed Chairman to take a further hawkish stance at its next policy meeting," Chowdhury added.

In the latest economic projections, FOMC expects US real GDP growth at 2.1% in 2023 before easing down to 1.5% in 2024 and 1.8% each between 2025 and 2026. Meanwhile, the unemployment rate is expected to be 3.8% in 2023, before breaching above 4% levels from 2024-2026.

Fed's main measure of inflation is expected to reach a 2% objective in 2026, however, will see a consistent decline between 2023 to 2025. For the current year, the inflation rate is projected at 3.3% overall, which is factored to drop to 2.5% in 2024 and further to 2.3% in 2025 before coming to 2% in the year after.

As per reports, Fed officials are optimistic about a "soft landing" ahead which means an easing in inflation rate without any pain to the economy. But it is evident that the FOMC is cautious and hence their 1 more rate hike trajectory by the end of 2023 proves that they are hesitant to not overdo and compress the economy more than it is required.

Further, economic data and key developments will be keenly observed for the Fed's rates prospects ahead. Also, as per reports, Fed officials believe the economy can avoid recession ahead.