Fed Raises Federal Funds Rate

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As expected, the Federal Reserve raised the federal funds rate by 75 basis points as part of its inflation-fighting efforts. Its target range will now be 3.00 to 3.25 percent. For comparison, during the descent from the 1970s inflation, then-Fed chair Paul Volcker raised rates as high as 20 percent.

The reason for today’s inflation is that the money supply has grown by 40 percent since COVID-19 hit, while real output has gone up by only about 4 percent. That imbalance changed the “exchange rate” between money and real goods—which is what inflation is. The Fed’s job now is to get the money supply back in line with what the real economy is doing.

Current Fed chair Jerome Powell downplays the role the money supply’s role in inflation, at least in public, but he is also interested in managing the public’s inflation expectations. Businesses often make supply chain and investment decisions months in advance and set prices based in part on what they expect prices to be down the road.

For Powell, managing inflation expectations means keeping the Fed committed to fighting inflation by raising the federal funds rate and tamping down on new money creation. It has been doing this since March, and will continue through at least the end of the year. Its next meeting will be November 1-2.

The concern is that getting inflation back under control risks an economic slowdown. That is why the Fed has not been more aggressive. Washington’s excessive COVID stimulus came at a price, which could end up being a recession, as well as high inflation. The Fed, Congress, and Presidents Trump and Biden made serious mistakes, and now the Fed is hoping to avoid the most serious tradeoffs.

The Fed still has plenty of room to be more aggressive. A 3 percent federal funds rate is still expansionary when core inflation rates are about 6 percent, and headline rates are above 8 percent. But this will likely not be the last interest rate increase, and the M2 money supply measure peaked in April and has stayed flat since.

There is a lag time before these actions make their way through the economy, and we are just starting to enter that window. That bodes well for inflation continuing to slowly fall, although Congress and President Biden’s continuing spending binges are making the Fed’s job harder than it needs to be.