The Fed’s Risky Rate Increase Helped Its Credibility to Reduce Inflation
The Fed increasingly has no good options, but it must restore price stability.
The Federal Reserve raised the federal funds rate again on Wednesday, in its latest move to bring inflation back down to normal. Most people were expecting the rate hike until Silicon Valley Bank and Signature Bank failed two weeks ago. A wait-and-see approach then became much more appealing to some. Even so, the Fed was right to raise rates this week, and it may be right to do so again at its next meeting in six weeks. A key reason is inflation expectations.
The money supply is king when it comes to inflation, but inflation expectations matter, too. Businesses care about more than just today’s prices when they make purchases from up and down supply chains. They care what prices will look like months (even years) from now, and they set their prices accordingly. People’s expectations, good or bad, can contribute to a self-fulfilling inflation prophecy.
If Fed chairman Jerome Powell wants to convince the public he is serious about getting inflation back down to its 2 percent target, he needs to stick to his guns, even with a possible banking crisis brewing. There is some history behind his thinking. His repeated emphasis on inflation expectations over the last year is straight out of former Fed chairman Paul Volcker’s (1979–1987) playbook.
Volcker’s predecessors William McChesney Martin Jr. (1951–1970) and Arthur Burns (1970–1978) were in charge for most of the 1965-1982 Great Inflation. They both more or less knew that too-loose monetary policy had something to do with high inflation, though they usually blamed other causes such as wage-price spirals, foreign-exchange-rate adjustments, and excessive financial speculation. Those assertions had some staying power; many pundits still make the same excuses today.
Sometimes those past chairmen even tried to slow inflation down. But almost the minute unemployment started creeping up, Lyndon Johnson or Richard Nixon would pressure Fed officials to restart the monetary printing press in time for the next election. Burns even supported Nixon’s wage-and-price controls ahead of the 1972 election.
Neither Martin nor Burns had credibility on inflation, and markets knew it. The public knew to expect high inflation indefinitely.
Paul Volcker took over in 1979 and spoke early and often about inflation expectations. After an initial misstep in supporting the Carter administration’s credit controls, Volcker raised interest rates and cut money-supply growth. When unemployment started going up and when the deepest recession in decades hit in 1981, he stuck to his guns. The federal funds rate that year topped out at over 19 percent. For comparison, this week’s increase brings it up to 5 percent.
The public got Volcker’s message, and inflation was back under control within three years of his taking office. Volcker later said that it would have taken just two years if he hadn’t supported Carter’s credit controls. Again, the money supply did most of the work bringing inflation back down. But expectations are one reason why inflation can linger, even after sound monetary policy is in place.
The Fed grew the money supply by 40 percent over two years when Covid hit, against just 4 percent real economic growth. Factor in a lag time of about a year for all that new money to circulate through the economy, and America got to 9 percent inflation. As usual, getting it back down is taking longer. Expectations are one reason why.
The Fed has already done most of the heavy lifting in terms of monetary policy. It ended its $5 trillion bond-buying program in March 2022 and has increased the federal funds rate from near-zero to 5 percent. If it increases interest rates again, it will likely be the final increase. Inflation numbers have already improved as a result. Yet, inflation remains above target.
Politicians used the pandemic as an excuse to go on a spending binge, and nobody expects them to stop. This ties the Fed’s hands somewhat, since it has to help finance all this new debt. But the Fed retains some independence, and Powell is using it to convince the public that adults are still in the room.
Read the full article at National Review.