In the family of scientific diagrams, the point diagram is something like the ugly duckling, a flock of simple splashes of color that simply cannot compete with their sometimes much more complex brothers and sisters. And yet this week the entire economic and financial world was waiting with great excitement for exactly such a dot plot, as it is called much more beautifully in English. Once a quarter, the monetary policy committee of the US Federal Reserve publishes a simple overview that provides information on how the key interest rates could develop in the medium term from the point of view of the body and what borrowing costs citizens, companies and financial markets have to adjust accordingly. Each of the small blue dots represents the anonymized forecast of one of the 18 committee members.
Six months ago, due to the corona pandemic, a clear majority of central bankers assumed that the subject of key interest rates would not be on the agenda at all in 2022. The economic situation seemed too fragile and the gap in the job market that the virus had torn too big. As of Wednesday, it has now been clear that this was a misjudgment: In view of the inflation rate of almost seven percent and a decline in the unemployment rate to 4.2 percent, the Fed wants to drastically change its course in the coming months and abandon the zero interest rate policy.
As the central bank announced after two days of deliberations by its most important decision-making body, it is not only the current economic support program that should expire much faster than previously planned. Rather, according to the dot plot, twelve of the 18 committee members are now assuming that in the coming year they will also be forced to lower the Fed’s most important key interest rate, the so-called overnight target range, from currently zero to 0.25 percent at least three times by a quarter point each time Raise 0.75 to one percent. That would be much faster than previously thought. Two committee members are even anticipating four steps for 2022 and a number of others for 2023. Based on the average forecasts, the rate could be around 1.7 percent at the end of the year after next, maybe even higher.
The Fed has an impact on economic development around the world
Should it come to that, it would have consequences far beyond the USA for loan interest rates and thus for home builders, car buyers, credit card owners and highly indebted governments, among others. As the guardian of the dollar, the world’s currency, the Fed’s decisions have an impact on economic, stock market and national debt developments on all five continents.
Federal Reserve Chairman Jerome Powell and his colleagues had long hoped that the rapid rise in many goods and service prices would only be a “temporary” phenomenon that would disappear on its own once the pandemic was overcome. For a long time there was a reason for this, after all, the high inflation rates in many countries are primarily an expression of the production and delivery bottlenecks that lockdowns and other restrictions have brought with them around the world. At the same time, many citizens have more money in their pockets than usual because they have received help from the state or have saved themselves expensive trips, for example. This results in a mix of high demand and low supply, which inevitably leads to higher prices.
A spiral of ever higher prices and wages would be economically dangerous
In the meantime, however, the rise in prices has also reached industries that are hardly affected by Corona. At the same time, many people are under the impression that the risk of permanently higher inflation rates is greater than expected. This has massive effects on investment decisions and wage claims and is an alarm signal for every central bank: It is not the increase in the price of individual goods that is dangerous from an economic point of view, but a spiral of ever higher prices and wages.
Powell had therefore stated in early December that the Fed was no longer assuming that the price hike was only “temporary” in nature. “Now is probably a good time to say goodbye to this term,” said the Fed Chairman at a congressional hearing. He also announced that his agency will reduce its massive purchases of US Treasuries and mortgage-backed securities more quickly than previously planned – a statement that the Monetary Policy Committee endorsed on Wednesday. So far, the Fed has pumped $ 120 billion into the economy month after month with the securities program in order to keep long-term lending rates low and to stabilize the economy after the outbreak of the corona pandemic. According to previous planning, purchases should be slowly reduced and completely abandoned in mid-2022. Instead, the central bank wants to end the program in March. This would also pave the way for the first rate hike since 2018 much earlier than previously thought.
For weeks, the White House has been trying rather unsuccessfully to lower the inflation rate
The decisions of the Fed not only have economic consequences, they also influence the political situation in the USA to a degree that has not been seen for decades. Although the economic data there is better than in the EU, for example, President Joe Biden is struggling with poor poll numbers. The most important reason – ahead of a number of other factors: the high rate of inflation. The situation is particularly dramatic for Biden because there are congressional elections in less than eleven months. If the Democrats lose their narrow majorities in the Senate and House of Representatives, the President would hardly have a chance to enforce laws. For weeks, the White House has therefore been working on a strategy to lower the inflation rate – but so far without resounding success. It is true that the price of oil and thus also of gasoline fell a little. However, this was less due to Biden’s measures than to the new Omikron variant of the coronavirus, which threatens the upswing.
The Fed is thus facing its greatest acid test since the global financial and economic crisis more than a decade ago. If she succeeds in convincing citizens, managers and financial markets through a few targeted interest rate steps and a clear communication strategy that she has inflation under control, the economic situation can relax again in the coming year. However, if it moves too slowly or too quickly, either the inflation wave threatens to swell further or an economic crash. In both cases, Biden’s Democrats would probably not even have to run in the November elections.