I therefore have only limited concerns about the domestic impact of a fast sequence of rate hikes – say, a 150-bps increase in March followed by two consecutive 100-bps hikes at the Federal Open Market Committee’s next regularly scheduled meetings. Should the need arise, the Fed knows by now how to provide funding liquidity as lender of last resort and market liquidity as market maker of last resort.
The adverse international repercussions of rapid rate hikes are more worrisome. The Fed’s bilateral currency swaps do not cover many financially vulnerable emerging markets and developing countries, and the International Monetary Fund has limited resources to function as a global lender of last resort. Owing to these constraints, it would make sense to pursue a slightly slower tightening cycle of, say, one 100-bps hike followed by five successive 50-bps hikes.
Either way, when it comes to the US economy, neither caution, prudence, nor the precautionary principle call for gradualism. The credibility of the Fed’s commitment to price stability is at stake. Unless the Fed raises interest rates rapidly to restrain aggregate demand, inflation will continue to overshoot its target. Long-term inflation expectations may not yet have become unanchored, but that is a real and growing risk.
Although the market-based five-year, five-year-forward expected inflation rate was 2.07% on February 15, 2022, short- and medium-term inflation expectations are already well above the Fed’s target. The Federal Reserve Bank of New York’s January 2022 survey of consumer expectations puts median one- and three-year-ahead inflation expectations at 5.8% and 3.5%, respectively. Similarly, the University of Michigan’s consumer survey in January 2022 put one-year inflation expectations at 4.9% and five-year expectations at 3.1%.
To safeguard its credibility, the Fed must take decisive action. Another drawn-out sequence of 25-bps hikes will not do the job.
Willem H. Buiter is an adjunct professor of international and public affairs at Columbia University.