Current position: Home » Opinions & Publications » Opinions » Content
Opinions & PublicationsPublications
Opinions

How will US contractionary policy affect the world economy?

He Ping 2022.06.01

High inflation and slow economic growth have cast a pall over the United States. The US Federal Reserve's responses – hiking rates and shrinking its balance sheet – may prove inadequate to contain inflation and stock market bubbles while keeping the economy growing.

There is some doubt that the US will manage to realize a soft landing for its economy. For the world, these contractionary actions present risks and challenges.

Accelerating the burst of asset bubbles in the US

In the early stages of the COVID pandemic, the US adopted a policy of quantitative easing, which substantially increased the liquidity of US dollar. The US economy slowed at the time because of COVID-induced supply disruptions. But the Fed flooded the market with an excessive supply of money, which failed to stimulate the economy as expected, and instead caused runaway inflation and asset bubbles. In March, 2022, the US saw its consumer price index (CPI) increase by a whopping 8.5 percent, a four-decade high.

This year, facing the soaring CPI and public outcry, the Fed had no choice but to raise interest rates even though the US economy had not fully recovered. In May, it hiked the rate by 50 basis points, its largest increase in 22 years.

After the 50-basis-point rise, the US saw asset bubbles shrink substantially and the stock market plunged for several consecutive days. Clearly, the contractionary policy was having side effects.

The current policy cannot both curb inflation and stock market bubbles and maintain economic growth at the same time.

In fact, the US is facing an unfriendly economic environment – both internally and externally – in hoping to control inflation. Internally, the US has not been able to identify powerful engine for further growth, and the fuel for economic recovery is in short supply.

Externally, the tariffs that the US has imposed on imports from China and other countries have increased the prices of imported goods. In addition, the COVID pandemic and geopolitical issues, along with America's contractionary monetary policy, weaken other economies' capability of bearing the negative externalities coming from US monetary policies.

Taking all these factors into consideration, it is very uncertain whether the US economy will manage to escape this quagmire.

In the future, the US will have to assess its economy's tolerance to the contractionary policy and its goals for curbing inflation before making further policy adjustments. In short run, keeping inflation under control is the top priority for US. However, if interest rate hikes and the shrinkage of the balance sheet hit the economy badly, causing a freefall in stock prices, a substantial increase in unemployment or other grim situations, the Fed will be forced to reevaluate the policy and slow its rate hikes.

US contractionary policies bring risks to the global economy

In the current international monetary system, US interest rate hikes will drive liquidity to flow back into the US market through most international financial institutions, causing a liquidity shortage for the global market. A shift from quantitative easing to a contractionary policy leads to a boom-bust pattern in asset prices for other countries, which leaves good opportunities for American investors reap substantial gains.

However, despite of the possible negative impacts for the US interest rate hikes, many economies will follow in the US' footsteps and adopt a contractionary policy to stabilize exchange rate and capital flow. What's worse, in a situation complicated by the ongoing COVID pandemic, these economies will find it more difficult to achieve growth.

What could be worse is that the world economy would confront a huge risk if the US economy suffers a hard landing that leads to economic and financial crisis.

However, opportunities come with risks. When the Fed hikes interest rate, the emerging economies could adopt relatively independent monetary policies to stabilize the economy, minimizing the impact of the fipnancial turmoil from international financial market while reducing the systematic risks. This would help to stabilize the global economy in a more substantial way.

China, for example, currently follows a monetary policy centered around its own needs to keep Chinese economy stabilized in building a land in the flood for the global economy.