THE International Monetary Fund (IMF) has warned the Federal Reserve (the Fed) — the US central bank — to avoid “misjudging the policy mix” it is using to calibrate the response to runaway inflation, because of the “sizeable costs at home and negative spillovers to the global economy”.

The US economy has recovered quickly from the pandemic shock as the positive effects of unprecedented policy stimulus, combined with the advantages of a highly flexible economy, have resulted in an unemployment rate that is back at end-2019 levels. Additionally, output is now close to its pre-pandemic trend, wages have increased rapidly for lower income workers, poverty has fallen, and 8.5 million jobs have been created since the end of 2020.

In this context, the IMF in its latest 2022 Article IV Consultation with the United States stressed that the policy priority must be to expeditiously slow price growth without precipitating a recession. The fund, however, concurred that avoiding a recession in the United States is becoming increasingly challenging due to Russia’s invasion of Ukraine, the lingering novel coronavirus pandemic, and supply side constraints.

So far this year, the Fed has increased its policy rates by 1.5 percentage points to contain inflation, which reached a new 40-year high 9.1 per cent in June from 12 months earlier — the biggest such increase since 1981. It is quite likely that the Fed will increase rates by another 2.0 or 2.5 percentage points in the coming months.

On Thursday, Christopher Waller, a member of the Federal Reserve’s Board of Governors, said he would be open to supporting a huge one percentage point increase in the Fed’s key short-term interest rate later this month if upcoming economic data points to robust consumer spending.

The Fed is also unwinding its holdings of Treasury bonds and mortgage-backed securities. As a result, the cost of borrowing has significantly increased. For example, the average fixed rate on a 30-year mortgage has already risen from three per cent to between five and six percent since the start of this year.

At the same time, the Government is reining in spending, as a range of pandemic-era support programmes are expiring.

“We expect these policy actions will slow the growth in consumer spending to around zero by early next year, easing the strain on supply chains. At the same time, higher mortgage rates will reduce housing prices, which have grown strongly during the pandemic. Finally, slowing demand will increase unemployment to around 5 per cent by the end of 2023, which should decrease wages,” the IMF said.

“All in all, we expect core PCE [personal consumption expenditure] inflation to fall back toward 2 per cent by late 2023, and economic activity to slow from 3.5 per cent in the first quarter of this year to 0.6 per cent (fourth quarter-over-fourth quarter) by end-2023.”

Risks ahead

The rapid rise in inflation and the Fed’s aggressive moves to contain it have also caused the IMF to cut its economic growth forecast for the US to 2.3 per cent for 2022. The previous estimate in June was that the US economy will expand 2.9 per cent, which was lower than the 3.7 per cent growth projection in April.

“The rapid recovery of demand and associated depletion of slack, rising energy prices, and ongoing global supply disruptions have led to a significant acceleration in inflation.”

“Wage and price pressures are broad based and have spread quickly across the economy. Longer-run measures of inflation expectations have started to drift higher and shorter horizon measures of inflation expectations have increased significantly,” it said in a statement.

The IMF said the US Government deficit rose to nearly nine per cent of its gross domestic product (GDP) with $1.9 trillion due to US President Joe Biden’s American Rescue Plan that was passed in March 2021.

“The fiscal deficit is now declining rapidly but, despite this, public debt is markedly higher than its pre-pandemic levels and is expected to continue to rise as a share of GDP over the medium term,” it said.