The US Federal Reserve is expected to release its policy statement and near-term economic forecast later today. While major changes to current policies are unexpected, the markets will be interested in understanding the Fed’s view on the recent higher-than-expected CPI which has further raised concerns on the increasing inflationary rate in the US.
Figures from the Bureau of Labor Statistics estimated the US Consumer Price Index at 5% year-on-year for the month of May. This came on the heels of an equally higher 4.2% year-on-year increase in April. Both figures broke a 13-year high while the core inflation rate of 3.8% remains the highest since 1992. Major drivers in the CPI include higher energy prices and rising food prices among others. The Fed had initially described April’s CPI as temporary, a reaction to supply-side bottlenecks caused by the pandemic. However, with continued inflation and increasing concerns about potential economic overheating, the Fed’s meeting will be expected to address these concerns.
What are the implications?
The potential implications of the current state of the economy could be divided across three lines. Foremost, rising inflation at a time of significant economic vulnerability puts the US Fed in a tight spot. As a central bank, it is charged with the twin function of controlling inflation and promoting employment. In reaction to the pandemic, the Fed launched a massive quantitative easing policy, combining ultra-low interest rates with an aggressive bond-buying policy (currently estimated at $120 billion monthly). This helped increase the money supply and steer the economy off recessionary directions (in combination with fiscal measures by the Treasury). Any change in policy, including an interest rate hike, would risk tightening the monetary supply with possible recessionary consequences.
Secondly, at the international level, a hike in interest rate would dramatically affect many countries and international corporations whose external debt is denominated in the US dollar. These debts are often tied to a variable rate like the LIBOR which reacts to US interest rate changes. Many economies are currently fragile and have largely financed their covid-19 response through debt as a result of reduced demand amidst the pandemic. Any hike in rate by the US Fed could significantly increase their debt interest burden. This could trigger defaults, austerity measures, and/or local rate hikes that would further drive the economy into recession.
Finally, interest rate decisions in the coming months could affect investor confidence in the dollar, with potential consequences for the values of other financial instruments. Decreased investor confidence in the dollar (as a result of untamed inflation) could trigger the traditional “flight to gold” as well as increased interest in cryptocurrencies such as bitcoin. While the latter has had its share of extreme volatility, there is no gainsaying the fact that an increasing number of investors continue to see bitcoin as a possible dollar hedge. Continued inflation and inaction from the Fed in the coming months could put this view to the test.
In the short term, the markets do not expect radical shifts from current policies. However, we expect increasing acknowledgment of the inflation problem from the Fed and preliminary talks on a possible decrease in bond buying. This could happen by the end of the year or early next year. How soon reduced bond-buying will be followed by an interest rate hike is an open question. Nonetheless, it is a question that could have significant consequences for many fragile economies across the world. In the meantime, increasing inflation could be good news to gold and bitcoin investors.