US Fed's inflation battle likely to cause greater harm to the world economy

The Federal Reserve’s battle to bring inflation under control will likely cause more harm to the US and world economy than is currently appreciated, according to a pair of papers set for presentation at a renowned economic conference this week.

Fed Chair Jerome Powell and his colleagues will probably have to push unemployment significantly higher in order to hit their 2% inflation target, according to one of the papers prepared for a Sept. 8-9 Brookings Institution conference. A second study warns of dangers for developing nations due to rising US interest rates and a strengthening dollar.

While a soft landing of the US economy is still possible, it’s only achievable under the most fortuitous of scenarios, Johns Hopkins University professor Laurence Ball and International Monetary Fund economists Daniel Leigh and Prachi Mishra wrote in their paper.

“The forecasts of Fed policy makers — inflation will return to target while unemployment barely rises above 4% — are reasonable only under quite optimistic assumptions,” they said.

Separately, former IMF chief economist Maurice Obstfeld and Princeton University’s Haonan Zhou saw trouble ahead for many emerging market and developing economies as the dollar climbs in response to higher US rates.

Those economies are particularly vulnerable because of a build-up in debt by the public-sector and businesses during the pandemic, much of it in dollars, they said. 

“Danger signals are flashing already,” they wrote. “A contractionary phase of the global financial cycle is now underway.”

Other risks loom if the Fed fails to get a handle on inflation, however, the duo wrote. That would be disruptive for the global economy in the longer-term and could erode the dollar’s role as the world’s key reserve currency, Obstfeld and Zhou said.

Ball and his co-authors attributed part of the overshoot of inflation to President Joe Biden’s $1.9 trillion American Rescue Plan, which they said contributed to a tightening of the labor market. Other factors include supply-chain shocks and rising energy prices.   

Powell and his colleagues are widely expected to raise interest rates further later this month as they seek to rein in elevated inflation without crashing the economy into a recession. 

In their last forecasting round in June, they anticipated doing just that.

Inflation was projected to fall to 2.2% by the end of 2024, from July’s 6.3%, while unemployment rises to 4.1%, from 3.7% now, according to their median prediction. Policy makers will update those forecasts at their Sept. 20-21 meeting. 

“Reducing inflation is likely to require higher unemployment than the Fed anticipates,” Ball and his co-authors said. 

The Brookings Papers on Economic Activity is a semiannual conference of top academics in Washington, to which numerous Nobel laureates have contributed since it began in 1970.

This story has been published from a wire agency feed without modifications to the text. Only the headline has been changed.

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