On Wednesday, the Federal Reserve raised its interest rate target (that is, the short-term interest rate they want to prevail in the market) by 0.75 percentage points, the biggest increase since 1994. The goal is to slow down the inflation rate from its current 8.6 percent rate.
Won’t this slow down the economy more generally or even cause a recession? Yes, that is exactly what the Fed wants to do. They would prefer not to cause an economic downturn but, if that is the price of reducing inflation, they are willing to impose that cost on us.
To understand what the Fed is up to, we need to look at its underlying model of inflation and how interest rate increases fit into that story.
The Phillips Curve and the Fed’s model of inflation
The Federal Reserve’s model of inflation is known as the Phillips Curve. It identifies three elements that drive the inflation rate.
First, the rate of inflation that businesses and households expect affects the current inflation rate. For example, if businesses expect inflation to be 3 percent in the coming year, they will try to raise their prices by 3 percent to keep up with inflation, thus turning their expectation into reality.
Higher expected inflation will lead to higher actual inflation. Thus, it’s important that the Federal Reserve ensure that people keep their inflation expectations low in order to keep actual inflation low. This idea, known as rational expectations, grew out of research conducted at the University of Minnesota and the Federal Reserve Bank of Minneapolis in the 1970s and 1980s.
Second, inflation results from an overheated economy, that is, an economy in which households, businesses, and governments want to purchase more goods and services (in the aggregate) than are currently available. Price increases (inflation) are the way that markets sort out this excess demand. The bigger the difference between desired spending and the available supply of goods and services, the higher the inflation rate will be.
Third, unexpected shocks to the economy can cause inflation to jump. For example, a sudden increase in the price of oil or some other critical commodity can push up the inflation rate even if it is forecast to be low and there is no overheating in the economy.
Interest rates, spending, and inflation
In its statement on Wednesday, the Fed noted that “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” So, the Fed’s diagnosis is that the second and third factors in the Phillips Curve (high levels of spending and unexpected shocks) are the causes of our current burst of inflation
This heightened spending stems from two sources. First, the Fed itself cut interest rates and eased credit conditions in the face of the COVID-19 pandemic. This was seen as a preventative measure to keep the economy from going into an even deeper recession than the one we experienced in the middle of 2020. Second, the federal government (under both the Trump and Biden administrations) enacted plans that sent checks to households, along with loans and grants to businesses, and a variety of other policies designed to cushion the shock of the pandemic and stimulate spending in its wake.
Both efforts succeeded. In retrospect, it may have been too much stimulus, but given the slow recoveries from the 2001 and 2007-2009 recessions, there was a sense in policy circles that too little stimulus had been applied in the past. This time, spending fell only slightly and by the time the economy began recovering in 2001 spending was outpacing the ability of companies to meet the demand.
These effects were probably wearing off in late 2021 and early 2022. The Federal Reserve planned to take only modest steps: raising short-term interest rates by small amounts (1/4 to ½ percentage points every 6 to 12 weeks) in 2022 and allowing long-term interest rates to be determined by market conditions.
Then, Russia’s invasion of Ukraine changed everything.
Oil prices and agricultural commodity prices shot up and supply chains reeled from the biggest war in Europe since 1945. In other words, the third factor in the Phillips Curve took on increased importance.
Thus, the Fed is now increasing interest rates higher and doing so more quickly than they expected to do earlier this year. The idea is that this policy will attack two of the three causes of inflation.
First, the Fed will keep expected inflation low by demonstrating that it is serious about fighting rising prices. People will have greater faith that the Federal Reserve will keep inflation in check. So far, this seems to be working according to data on inflation expectations derived from the bond markets but is shaky in surveys of consumers.
Second, higher interest rates will discourage spending by both households and business by increasing borrowing costs and by making saving money more attractive. This will bring spending closer to available supplies of goods and services and thus reduce the effects of overheating on inflation.
Taking risks
To summarize: The Federal Reserve is raising interest rates in order to reduce consumer and business spending. Lower spending will cool off the economy and cause inflation to fall – which is what the Fed wants. However, lower spending will also reduce the demand for workers to produce goods and services, thereby increasing unemployment.
Can the Fed do this without throwing the economy into a recession? That is the $24 trillion question.
On the one hand, we currently have a situation where the number of job openings exceeds the number of job seekers and so the Fed’s policymakers hope that by slowing down the economy the number of openings will decline without throwing current employees out of work.
On the other hand, it’s possible that the Fed could raise interest rates so high and/or so quickly that households and businesses cut back on their spending sharply, GDP falls, and unemployment rates rise.
The Federal Reserve is willing to take this chance because they believe it took a deep recession from 1981 to 1983 to kill off the inflation of the 1970s. They do not want anyone to think they are not vigilant about fighting inflation and are willing to put the economy into a recession to prove it.
The President and Congress could help the Fed (tax increases, anyone?) but they would rather let the unelected members of the Fed’s Board of Governors take the blame for a recession rather than risk their own chances at the ballot box.
Susan Riley contributed extensively to this column.
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