July 13, 2022
The US economy has quickly rebounded from the pandemic, but the increase in demand has put a strain on supply chains and driven up inflation. As the COVID economic relief measures come to an end and the Federal Reserve (the Fed) continues to tighten monetary policy, the economy is anticipated to decelerate, bringing core Personal Consumption Expenditure (PCE) inflation to the Fed’s medium-term target of 2 percent by late 2023. But if inflation persists longer than anticipated, the Fed will have to tighten even more, which will cause the economy to slow down even more.
The policies required to bring inflation back to the Fed’s medium-term target are the main subject of the IMF’s yearly assessment of the US economy. The majority of workers’ pay has not kept pace with inflation, which has had a considerable negative impact on household purchasing power. Despite the fact that global events have contributed to increases in petroleum and food costs, a wider variety of goods, such as housing and transportation, have also seen sharp price increases. These price hikes could become persistent if they are not stopped. According to our analysis, the Fed needs to take swift action to combat inflation and re-establish price stability.
POLICY ACTION
This year, the Fed has hiked its policy rates by 1.5 %, and it is expected to raise them by another 2 or 2.5% in the months to come. Additionally, it is selling off its mortgage-backed securities and Treasury bonds holdings. As a result, borrowing has become much more expensive. For instance, since the beginning of this year, the typical fixed rate for a 30-year mortgage has already increased from 3 % to between 5 and 6 %. In addition, the government is reducing spending since a number of assistance programs from the pandemic era are coming to an end.
By early next year, we anticipate that these policy changes will have reduced the growth in consumer spending to roughly zero, alleviating the pressure on supply chains. Higher mortgage rates will also lower house prices, which have sharply increased throughout the pandemic. The unemployment rate will reach about 5% by the end of 2023 as a result of declining demand, which should result in lower earnings.
Overall, we anticipate economic activity to decelerate from 3.5 % in the first quarter of this year to 0.6 % by the end of 2023 and core PCE inflation to return to 2 % by late 2023.
RISK AHEAD
Global variables including the ongoing epidemic, the Russian war with Ukraine, and potential shutdowns in China will have an impact on US economic prospects. Additionally, the longer inflation is high, the greater the chance that inflation expectations will rise, which will have a negative feedback effect on wages and prices. The Fed would therefore need to move more forcefully to reduce inflation, hiking interest rates and maintaining them there for a longer length of time. This would further slow growth and increase unemployment.
AN INCLUSIVE RECOVERY
Even though the Fed policies necessary to reduce inflation may have immediate costs for individuals and businesses, they will help restore price stability and lay the groundwork for robust economic development and low unemployment. The US government can invest in reforms to increase the size of the labor force, increase productivity, and encourage investment and innovation through fiscal policies to boost growth over the medium to long term. Increased government funding for paid family leave, childcare, preschool, and access to a college education could be among them. Other examples include tax credits that encourage women, minorities, and low-income workers to enter the workforce, as well as immigration reform that aims to increase the labor force and improve skills.
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