Fed Credibility Depends on it Continuing to Raise Rates

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Today’s federal funds rate hike is good news because it signals commitment. That will help the public to expect the Fed to continue to fight inflation, rather than stop its efforts so it can focus instead on recent bank failures.

The Fed’s credibility matters here because the public’s inflation expectations can contribute to a self-fulfilling prophecy, good or bad. When businesses set their prices and make purchases up and down supply chains, they think about more than just today’s price. They think about what prices will be months from now, or even years. If they expect high inflation to continue, they will buy less and charge more. Households plan similarly, especially for long-term purchases like houses, cars, tuition, and investments. 

Fed Chair Jerome Powell knows this. That is why he emphasizes public expectations in nearly all of his public remarks, and has been more open than previous Fed Chairs about his rate-raising plans.

If Powell were to go back on his word to address the political concerns of the moment, he would lose credibility. The public would call his bluff and expect inflation to continue, making Powell’s job even harder than it already is. His failed predecessors William McChesney Martin and Arthur Burns made this mistake back in the 1960s and 1970s. 

The public back then knew that if the Fed had to choose between controlling inflation or stimulating the economy, stimulus would win every time—especially during Lyndon Johnson and Richard Nixon’s reelection years. Burns even favored unprecedented wage and price controls over doing the hard work of tightening money and raising interest rates, which would have angered President Nixon. The result was a disaster, and even higher inflation that lasted for nearly another decade. That can’t happen again today, even if a banking crisis emerges.

Today’s public knows that if the Fed will react to every setback by pulling back into its shell like a scared turtle, then it will never get around to finishing the job. Life is full of setbacks, but that is no reason to give up when something has to get done.

That’s why the Fed’s good decision today is important. Staying the course and raising interest rates sends a signal that yes, the Fed means what it says about getting inflation back down. Even if there are more bank failures, the Fed needs to continue to raise interest rates and to keep money supply growth in check until inflation is finally back to its two percent target.

A wait-and-see approach, which many Fed critics were calling for after Silicon Valley Bank’s failure, signals instead that politics is more important than inflation. This might be true in Washington, but not in the real world.

It is concerning that Chair Powell was less decisive about the Fed’s interest rate decision at its next meeting, which will be in six weeks. Even accounting for long lag times that follow interest rate changes, it is likely that another rate increase will be necessary, both to keep the money supply in line with real economic activity, and to let the public know that it can expect the Fed to finish what it started. 

The money supply is the most important factor in inflation, but expectations also matter. The Fed has already done most of the heavy lifting on the money supply. In order to keep expectations in line, it now needs to stay the course. Moments like right now are when the Fed most needs to maintain its credibility.