The United States Federal Reserve lived up to expectations by hiking its benchmark Fed Funds rate by 0.5 percentage point on Wednesday to between 0.75 and 1 per cent. But whether this will be able to quell inflationary pressures and pull off a soft landing for the US economy remains an open question. This was the biggest rate hike from the Fed since 2000 and its chairman Jerome Powell signalled that there are likely to be two more of the same size in June and July, which financial markets had already priced in. To their relief, Mr Powell indicated that a 0.75 percentage point hike - which some hawkish Fed officials favoured - was not something that the committee is actively considering. In response, stock markets rose sharply and bond yields declined.
The Fed's moderate stance suggests that it is mindful of the dangers of overdoing rate hikes, which could send the US economy into recession. Mr Powell acknowledged the Fed faces a challenging balancing act, but claimed there is a good chance of "a soft, or soft-ish landing" for the economy. The jury is still out on that call. Interest rate hikes can only reduce demand pressures. Mr Powell pointed to the US economy's labour shortages, stressing the need to prevent wages continuing to be eroded by inflation - which could set off a wage-price spiral. But even if the labour market is brought back into balance through slightly higher unemployment and lower demand, inflationary pressures from high prices for fuel and food because of the Russia-Ukraine war as well as disruptions to supply chains arising from lockdowns in China will persist. These are supply-side problems the Fed cannot directly address. Moreover, with the Fed funds rate now expected to be 2.5 to 2.75 per cent by the year end and with US consumer price inflation at 8.5 per cent, real interest rates will remain substantially negative, which would not be anti-inflationary. Some liquidity will be withdrawn from the economy by the Fed gradually reducing the size of its balance sheet from June onward, but this would more likely take its toll on financial markets than on inflation.