Excessive hike in interest rates was feared: is the Fed choking the economy?

As of 07/27/2022 12:12

The US Federal Reserve is on a narrow path of rate hikes. Many experts fear that the Fed may end up slowing the US economy down. It would also have consequences for Germany.

Author: Angela Göpfert, tagesschau.de

The US Federal Reserve is likely to make another large rate hike tonight after the end of its two-day meeting. According to Fed Watch Tool of the CME group, 75.1 percent of market participants expect an increase of 75 basis points; 24.9 percent it even expects an increase of one full percentage point.

While the European Central Bank managed to raise interest rates for the first time in more than a decade just a week ago, the Federal Reserve (Fed) has already taken significant steps in the past to bring inflation back under control. In June, it raised the interest rate by 0.75 percentage points to 1.5 to 1.75 percent – more than ever since 1994.

Fed policy is a risk for Germany?

However, the Fed reacted strongly to the sharp rise in consumer prices – in June the inflation rate in the US stood at 9.1%. – carries a serious risk: the resulting economic slowdown may lead to a recession, i.e. a decline in American production.

It would then also have clear ramifications for the rest of the world; for Germany, the USA is even one of the most important trading partners. A fall in US demand would hit hard the export-oriented German economy, which is already heavily damaged by supply and energy bottlenecks.

Inverted yield curve – a warning signal from the bond market

In any case, high inflation forecasts and the Fed’s expected reaction to them have already left their mark on the bond markets. The yield on two-year US government bonds is higher than the yield on ten-year US bonds. Market experts talk about an inverted yield curve.

This is an extremely unusual pattern that worries both traders and economists. Experts see this “inverted world of interest rates” as a negative signal for the world’s largest economy. The inverted yield curve is seen by many as a herald of recession.

In fact, the bond market has proven to be a reliable early indicator of an economic slowdown: according to a study by the Federal Reserve Bank of San Francisco, every economic downturn in the US since 1955 has been preceded by an inverted yield curve with one exception.

Does the Fed take recession concerns seriously?

Against this background, the comments of the Fed chairman Jerome Powell on the future rate of the central bank will probably be in the center of attention, apart from the level of today’s interest rate hike.

Jochen Stanzl, chief market analyst at CMC Markets, said: “With growing fears of a recession, investors are beginning to hope that the Fed can slow the rate hike significantly after Wednesday’s hike.” In June 2023, the market now expects the first key rate cut once again.

Market expert Robert Rethfeld even sees the Fed at the end of the interest rate hike cycle: “Fed Funds Futures still point to the end of the interest rate hike cycle as early as November 2, 2022.” It is imaginable that market participants “expect a statement at today’s press conference that the Fed is taking recession fears seriously, despite a growth valued at 75 basis points.”

The window for rate hikes is small

The US central bank takes a completely different approach than its European counterpart: instead of uncertainly raising interest rates, the Fed focuses on quick, rapid interest rate hikes. The reasoning behind this is clear: “The markets are now in recession or at least a sharp slowdown in growth from the end of the year,” explains Franck Dixmier, chief bond strategist at Allianz Global Investors.

“Therefore, the Fed needs to act now to anchor inflation expectations at a low level and provide room for maneuver later.” Apparently the US currency watchdogs are aware that the time window for interest rate hikes is likely to be extremely short given the clearly oncoming economic slowdown.

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