MOST major banks have only one mandate – to achieve price stability so that economic growth can be achieved, and financial stability is contained.

       However, the US Federal Reserve (Fed) system has dual mandates – price stability and maximum employment.

       For most central banks, when inflation is at 2%, it is considered as price stability.

       The definition of maximum employment, however, is vague since it depends on the structure of the labour market.

       While this sounds easy on paper, trying to achieve price stability is a complex process in practice, since it requires many different tools and multiple strategies subject to the situation at hand.

       The Fed has faced two unprecedented crises that forced it to re-strategise its monetary policy approach. The first one was in the late 70s when the Fed tightened its money supply by increasing the interest rate up to 20% in an attempt curb prices that had surged significantly.

       It was done at the expense of the economy where the unemployment rate jumped and financing costs for farmers and business became too expensive.

       The second was during the global financial crisis when the Fed had to push the fed funds rate to the lowest level possible to keep the economy going and avoid falling into price deflation – a situation the Japanese economy had faced in the 2000s, which could lead to an even longer economic malaise.

       The Fed is facing a mix of both situations. During the early stages of the pandemic in early 2020, the Fed responded by slashing the fed funds rate and reintroducing its large-scale asset purchase programme to cushion the pandemic’s adverse effects on the economy.

       After almost two years, the situation became better, as the economy has reopened.

       More people have been vaccinated, business and consumer sentiment remains healthy, and the labour market is tight and strong.

       Massive liquidity

       Owing to the massive liquidity that was pumped into the market, most economists argued that it was the sole reason why inflation has been creeping up recently.

       With the low interest rate and quantitative easing, financing cost has become low, thus putting pressure on prices through the demand-pull.

       However, some economists disagreed, saying that the main reason for the high inflation was due to cost-push factors, such as supply bottlenecks, higher commodity prices, and higher input and output costs.

       There were others who believed that the high prices were caused by a combination of both.

       Spectre of inflation

       Regardless, the Fed’s mandate of achieving a 2% inflation rate is far-fetched, as the latest inflation number as of March was 7.9% – the highest reading ever recorded in this millennium.

       The Fed responded to the high inflation by increasing the fed funds rate by 25 basis points (bps) in March.

       However, many indicators signalled that the price pressure will not cool off soon.

       The Fed has indicated that it was willing to be aggressive in adjusting the fed funds rate, including hiking by 50bps at the next meeting, and will continue to make adjustments in the upcoming meetings.

       This means that the cost for financing will become higher due to the interest rate increase.

       On a side note, the Fed’s balance sheet will be trimmed.

       As of the end of March the Fed holds around US$5.8 trillion (RM25 trillion) of the US Treasury Securities and some US$2.7 trillion (RM11.4 trillion) of mortgage-backed securities.

       Quantitative tightening

       The process is called quantitative tightening (as opposed to quantitative easing). Intuitively, when the Fed slows down or stops purchasing the securities, long-term interest rates will go up, meaning the cost of purchasing goods that require long-term commitment such as mortgages and vehicles will be higher.

       The main dilemma that the Fed is facing now is whether it could tolerate the high interest rates at the expense of the economy.

       The unemployment rate is at 3.6% which is the lowest since the pandemic. However, history has shown that high interest rates will dampen economic growth.

       Apart from this, the conflict between Russia and Ukraine, China’s lockdown due to its zero-Covid policy, and further supply chain disruptions are other risks that could force the Fed to rethink its strategies going forward.

       Across the Atlantic, the European Central Bank’s (ECB) dilemma is slightly different.

       Due to the significant share of external trade it has with Russia, especially in the energy category, any volatile moves seen in the global markets could roil the regional economy and exacerbate the already red-hot inflation that the ECB is facing.

       Compared with the United States, Europe’s economy is more subdued and its recovery progress is not that impressive, especially after the sudden Omicron-driven outbreak.

       Most countries in the region had reintroduced lockdowns and pandemic regulations, constraining the recovery it had made over the past one year.

       Furthermore, the recent outbreak in Shanghai, one of the most important port-cities in the world, only made it worse as it could further strain the global supply chain network, pushing up transport prices and ultimately leading to the consumer price increases.

       Therefore, the region is facing a looming stagflation as the higher price could hinder consumers from buying and in turn, weaken private consumption and economic growth.

       For perspective, the March preliminary inflation rate was 7.5% year-on-year – a new record high for the region.

       Policy path

       Therefore, it is imperative for policymakers to tread cautiously in laying down the policy path.

       The Fed and ECB could learn from the Bank of Korea (BoK).

       In May 2021, South Korea’s inflation was 2.6%, which was above its target of 2%. The central bank took a pre-emptive measure by increasing the interest rates by 25bps in August 2021. This was followed by more hikes in October 2021 and January 2022, pushing the rates to 1.25%.

       During these periods, there were concerns that the outbreak of Omicron-related cases could force central bankers to keep their monetary policy accommodative.

       Most central banks saw the price pressure as “transitory”, which explained why most were not reactive even though inflation has breached the desired target.

       While the BoK was praised for adopting the pre-emptive measures, price pressure did not subside.

       Inflation continued to increase, averaging from 2.4% in the third quarter 2021, to 3.7% in the fourth quarter 2021.

       The reasons inflation remained high were similar to those of other economies – higher commodity prices, supply bottlenecks, and higher input and output costs. These are issues that central banks have little ability to address. As of now, we are positive that the Fed will continue to be hawkish and rein in the surging inflation.

       For the ECB, its recent meeting minutes showed that a majority of members held the view that there is a need to step up policy normalisation and thus, revised the ending of the asset purchase programme to June from September.

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