Inflation isn’t a well-kept secret. Most people have noticed that the cost of everything from cars to milk has gone up quite a bit in the past year. In response to concerns about runaway inflation, Federal Reserve Chairman Jerome Powell announced a 0.5% increase to benchmark interest rates last week with plans for further increases in the coming months.
As with most major monetary policy decisions, discussions are occurring about the chosen course. Is this increase too little, too late, not enough, or just right? Powell himself has noted that he believes the chances are good of a “soft, or ‘softish’ landing” for the US economy instead of a hard crash into recession as was seen in the 1980s when the Fed tried to reel in inflation.
Today, we’ll cover what’s happened and the near future for interest rates and the US economy.
What’s the Current Economic Situation?
The inflation rate for March 2022 was 8.5%, the highest it’s been in roughly 40 years. The first notable increase was in April 2021, when it jumped from 2.6% to 4.2% within a month. Through the remainder of 2021, inflation has gradually increased to where we’re at today.
The result has been notably increased prices across the spectrum. From lumber, to food, to energy, to heavy machinery, costs have shot up in such a period of time that the Fed could no longer wait the situation out without changing policy.
What is the Fed Doing About Inflation?
Last week, Fed Chairman Powell announced a half-point increase to interest rates. The chairman also strongly suggested that when the Federal Open Market Committee (FOMC), the voting body of the Federal Reserve, meets next in June, they will decide to add another half percentage point to interest rates.
Traders are already speculating that the FED will actually add a three-quarter-point when June comes around, as the actions taken thus far have been too little too late to reel in inflation. Even Powell acknowledged this in a Senate hearing this March, saying. “Hindsight says we should have moved earlier,” in response to Sen. Richard Shelby’s question if the Fed got caught sleeping.
The general consensus amongst policy wonks is that the goal will be a 2.5% rate by the end of 2022 and 3.0% by the end of 2023.
How Did the US Economy Get Into This Situation?
Depending on who you ask, you’ll either hear that this began in 2020 with COVID or in 2008 with the Great Recession. In response to the crisis of 2008, interest rates were slashed to nearly 0% to encourage the lending and borrowing needed to kickstart the economy. These ultra-low rates stayed in place for years, only beginning to increase by the Summer of 2016. Even then, the increases were tepid, as no one wanted to be held responsible for damaging economic recovery or even throwing the nation back into a recession.
Just prior to COVID striking in 2020, the rates had reached around 2%, keeping pace with inflation. By all measures, it was still historically low, as you can see for yourself. As soon as COVID hit, rates were slashed to almost nothing, once again.
Some have argued that the Fed should have increased rates higher, earlier, because once we were in the COVID crisis, they didn’t have anywhere to go with the interest rate. Zero is as low as you can go before, in something of an alternate reality, there would be negative interest rates, and borrowers would be paid to borrow. It’s clear that’s not happening, but when borrowing is almost free to do, there’s very little the Fed can do to spur economic activity.
What is the Fed Trying to Accomplish?
The Fed is trying to slowly but surely bring inflation down without sending shocks through the stock market, labor force, or supply chain. The disruption caused by COVID resulted in the current ongoing supply chain crisis. There is a delicate balancing act of reeling in the affordability of borrowing to deal with inflation, but not doing it so aggressively that it will spook the business community and economic activity dries up.
What does that mean in human terms? Okay, right now, businesses on all ends of the supply chain are struggling with being backed up or unable to get the supplies they need. Things are jammed up, and it’s been a mess trying to sort it all out. Ships are waiting to get into ports. Ports are running out of places to store shipping containers while they sit, waiting to get transported to warehouses. Warehouses and shipping companies don’t have the drivers they need to get everything done. It’s not a great situation, to say the least.
Hypothetically, in the best-case scenario, where all these different industries were suddenly on the same wavelength and had everything they needed to get it done…it would result in a traffic jam at every node on the chain. This hypothetical is just to point out that almost nothing but time and regularity will help untangle the Gordian Knot that is the current supply chain. How do you eat an elephant? One bite at a time.
Now, with all that in mind, and remembering that we’re talking about the Fed increasing the cost of borrowing, imagine if businesses got scared by rate increases and said to their suppliers, “you know that order I made? the one that’s been on its way for a while, yeah, cancel it. I don’t want it and if you deliver it I’m not paying for it. Keep my deposit, I don’t care.”
This could, in turn, create a deflationary spiral where businesses now have produced and shipped goods that no one wants, so they lower the prices. The market becomes flooded with cheap everything. In response, businesses start laying workers off as there is already a supply glut, and there’s no point in producing more.
This scenario is exactly what the Fed was and is trying to avoid, and is likely the very reason that they waited so long to deal with inflation. As Chairman Powell told Congress, the FOMC just thought that supply was going to be able to catch up before inflation became too much of a problem. It didn’t, and now we’re here.
Learning From History
The Fed has laid out its plan of action, and it’s always a possibility that it’s playing a little coy as to soothe nervous investors. Every statement made by a Fed chair should be assumed to have an asterisk above it, meaning “maybe.” What can be said for sure is that the Fed is absolutely trying to avoid repeating its response to the inflation of the early 1980s, where interest rates were raised to 20.00%, and, just as I described in the prior section, all economic activity crashed. The hope is to put a damper on inflation, continue to make borrowing a viable opportunity for businesses, and slowly turn our economic ship towards the breaking waters, not perpendicular to them as we are now.