US inflation – still a problem

Executive summary

High inflation was rampant in 2022, eroding real income, disrupting the financial markets, and weighing on the economy. To tame it, the Federal Reserve (Fed) has been hiking interest rates since March 2022, by a cumulative 475bps till April 2023. It also started tapering around the same time. Although inflation was moderated, pushing it back to the 2% target still requires more work. Liquidity shrinking and high interest rates resulted in a banking crisis, prompting the Fed to slow interest rate hikes and even completely revise the direction of monetary policy. The 2023 outlook is gloomy, shadowed by the high interest environment, a still resilient labour market, volatile energy prices, and financial system instability.

What ailed the US economy in 2022?

High inflation best characterises the world economy in 2022. CPI in the US was 8.1%, the highest in 40 years. High inflation and consumption have been eroding savings accumulated amid the pandemic, resulting in slower growth in private expenditures and demand for higher wages. Disruption in commodity markets induced by the Russia-Ukraine war also pressured inflation from outside. Aiming to fight against surged domestic CPI, Fed’s aggressive interest rate hikes suppressed consumption and investment. In 2022, US real GDP growth slowed to 2.1% y/y from 5.9% in 2021.

Factors pushing up inflation

US inflation started to soar in April 2021, and peaked in June 2022, under the pressures from both the demand and supply side. Loose monetary policy and stimulative fiscal policy amid the pandemic were the main drivers of strong aggregate demand. While supply-chain disruptions played a significant role in increasing the US PPI, Russia-Ukraine conflict also sent food and oil prices to their peaks, driving up headline inflation. High Services CPI bolstered by housing rents and wages was bringing tenacity to this wave of inflation.

The Fed’s fights against high inflation

In March 2022, when US CPI soared to 8.5%, the Fed began a hawkish interest hike cycle to fight inflation. The Fed funds rate increased by a cumulative 475bps till April 2023, raising the target range of the Fed funds rate to 4.75-5%, the highest since October 2007. Headline inflation stepped down while core inflation stood more steadily above central banks’ comfort levels, and its easing trend has been offset by a sharp rise in service inflation. Almost simultaneously with its interest hike, the Fed planned to shrink its balance sheet by USD80bn a month, on average, from June 2022, aiming to reduce its size from USD8.94tn to USD5.9tn in the coming three years, pushing the market rates even higher.

Side effects have emerged. Liquidity was strained due to the interest rate hikes and tapering, forcing banks to sell long-term fixed income products to meet short-term withdrawals, resulting in the Silicon Valley Bank’s bankruptcy, and Credit Suisse’s crisis due to the spill-over of market panic.

A gloomy outlook for 2023

Although US inflation has moderated from its peak amid the Fed’s aggressive tightening monetary policy, the economic outlook for the US is still gloomy in 2023, as predicted by the inverted interest curve. The high interest rate environment and quivering banking system, a still tenacious labour market along with lingering external pressure on commodity prices are all adding uncertainties on US economy.

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