(Bloomberg Opinion) -- The U.S. Federal Reserve is widely expected to raise interest rates by at least a 25 basis points next week. And if inflation stays high, the Fed is “prepared to raise by more than that” in the coming months, Chair Jerome Powell said last week.
That would be a mistake. After next week’s hike, the Fed should hit pause for at least the next several months and possibly through the summer — even though the war in Ukraine will no doubt make inflation worse in the U.S.
It’s unclear how bad the conflict will get, the effect it will have on the region and whether it will lead to a global recession this year. The probability of that last is less than the most extreme predictions, but is nonetheless real.
A more aggressive Fed might use a recession as an opportunity to rapidly bring down inflation by sticking to its rate-hike schedule. That is risky policy, and one that Powell seems disinclined to take. If a recession hit, it’s likely that the Fed would simply have to reverse any rate hikes it had made in the preceding months.
A see-saw pattern in rates would weaken the overall impact of the Fed’s policy. Consider, for example, the plight of a homebuilder who cuts production next summer in response to rising rates. She is not likely to increase production immediately if rates fall in December; she’d want to wait for a signal that rates will remain low for a while. From the Fed’s perspective, it would be more effective to leave rates alone, encouraging her to keep production high for the next several months.
There are also risks to consider beyond outright recession. The direct costs of higher energy and food prices will cut into consumer savings. Even more important, spiking commodity prices are likely to dent consumer confidence, leading to reduced spending on other items.
Another consideration is the effect of the war on developing markets around the world. Higher food and energy prices will hit their economies harder. Global uncertainty will lead investors to move funds out their markets and into the U.S. That could cause a drop in the demand for U.S. exports, which are geared toward investment goods such as heavy machinery. That would reproduce some of the effects of the mini-recession that swept the Midwest in 2015 and 2016.
At the same time, money flowing into the U.S. from both developing markets and Western Europe will cause the dollar to rise and the relative prices of imports to fall. As consumer spending shifts toward imports, that will cool some of the underlying inflationary pressures in the U.S.
The near-term environment is complex. It’s unclear how long the war will last and how far-reaching its effects will be. The ideal Fed response, however, is straightforward: Go ahead with the rate hike next week. But make it clear that there won’t be any more for at least two more meetings, and then only as the fallout from the war in Ukraine becomes more certain.
Related at Bloomberg Opinion:
- What Europe Has to Do to Unhook Itself From Russian Gas: Liam Denning
- Working From Home Can Reduce the Russian Energy Shock: Brooke Sutherland
- Housing Already Had Problems. Now Comes the Fed: Conor Sen
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Karl W. Smith is a Bloomberg Opinion columnist. He was formerly vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina. He is also co-founder of the economics blog Modeled Behavior.
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