Federal Reserve Raises Interest Rate; Uncertainty Strengthens Case for a Policy Rule

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As expected, the Federal Reserve raised the federal funds rate by 0.75 percentage points coming out of this week’s Federal Open Market Committee (FOMC) meeting. It will also likely raise rates again at its next meeting in six weeks. Raising interest rates is one of the Fed’s main tools for fighting inflation, so the rate hike is good news for several reasons.

One is that the federal funds rate is still lower than inflation, which means the Fed is still essentially paying banks to take out loans. This is a lousy incentive structure, as anyone who was around for the 2008 financial crisis knows. The rate needs to go up until it better fits the inflation rate.

The federal funds rate will now rise to a range 3.75 to 4.00 percent, while the main consumer price index inflation rate currently reads 8.2 percent over the last year. The true rate is likely closer to the current core personal consumer expenditures price index reading of 5.1 percent. The Fed’s target rate should land at least that high until those inflation numbers go down.

A lower-than-inflation federal funds rate can also cause more inflation. That is one reason why the Fed signaled it will continue to raise rates going forward.

Fed officials also hedged on how much the increase will be, in part because they don’t know what the economy will look like six weeks from now. It is even possible tat the inflation rate will finally begin to slow, though that is no sure thing.

The Fed began pulling back its excessive COVID-related stimulus in March. The Fed grew the country’s money supply by 40 percent in just two years, which has never happened before in U.S. history. A drawback of anything of such enormous scale has a long lag time before the effects show up in the inflation rate. We are now at what is likely the beginning of that window, but we don’t know for sure, so Fed officials are reluctant to commit to any actions just yet.

Fed officials are also under political pressure to keep rates low, because higher interest rates make government debt more expensive to repay. That makes current and upcoming spending hikes more difficult to pay for, which Congress and the president dislike. There is also fear that aggressive rate hikes could cause a recession. While at this point that would have no midterm election ramifications, the 2024 campaign is already underway.

So, today’s rate hike is good news, but small potatoes. The Fed is fixing its mistakes, but slowly.

Going forward, reformers should look to institution-level reforms. It is not enough to adjust interest rates or the money supply. The Fed has structural problems that make it less effective at keeping inflation in check.

One such solution, binding the Fed to pre-set policy rule, would have a trifecta of positive effects. Under such a rule, if the economy grows by a certain amount, the Fed automatically responds with a proportionate interest rate adjustment or change in the money supply. That takes away the discretion that Fed officials currently wield.

The first positive effect of a policy rule is the biggest. It would have prevented the Fed from causing runaway inflation in the first place. Officials lost their cool when COVID-19 hit, and badly overreacted. They should have loosened monetary policy, but not by $5 trillion. If they were bound by a policy rule, they would not have been able to do that in the first place. A rule would also have prevented the Fed’s overly aggressive tightening that worsened both the 2008 financial crisis and the Great Depression.

Second, it adds certainty to the economy. When rates move at the FOMC’s discretion, it makes long-term planning difficult. If everyone knows in advance how the Fed will react to economic movements, planning and investment are much easier. There will also be less malinvestment, since prices contain less misinformation. And inflation expectations will remain stable, which is something Fed Chairman Jerome Powell takes seriously, although he is opposes committing the Fed to a rule.

Third, a policy rule would strengthen the Fed’s political independence. There is a long bipartisan tradition of politicians pressuring the Fed to stimulate the economy before elections so those numbers look better to voters. If the Fed did not have the discretion to oblige, it could point to the rule and inform the president that it is unable to help.