To combat what seems like a prolonged period of runaway inflation, the Federal Reserve has stated it plans to raise interest rates six times over the course of this year.
While this certainly came as a shock to investors, especially those who had hoped for a continuance of the zero interest rate policies from the Fed, it does not signal a recession is imminent, as many have suggested. The media has enjoyed throwing around the statistic that the Fed has forced a recession in eight of the last nine instances in which it tried to rein in inflation by raising interest rates. But just because the Fed has had difficulty in the past calibrating its tightening measures in ways that put a lid on price advancements and still allow for economic growth, it doesn’t mean policymakers are perpetually hamstrung in fighting inflation. The Fed has learned much as a result of those experiences, and as banal as it may be, this time really is different.
We have been in a low-rate environment for a very long time, and because if this—and because the Fed has drastically expanded its balance sheet through unconventional methods—it can tighten, while at the same time present favorable business conditions which incentivize investment. The notion that the only way policymakers can get us out of this bout of high inflation is through a Fed-induced recession—raising rates to the point where investment is crippled and prices fall—may have been a reality of past decades, but it certainly isn’t the case today. Despite what many have portrayed, the Fed is actually in a pretty good policy space.
Assuming the Fed raises the policy rate twenty-five basis points on six different occasions, such action only translates to an interest rate increase from the current policy target of fifty basis points to a target rate of two-hundred basis points. Now if you were to ask any economist, seasoned or not, they would tell you a two percent Fed-funds rate is a far cry from “tight money.” If anything, a two percent policy rate is “easy money” policy conducive to continued credit expansion. This is one reason why we should not be as worried about growth as the financial press would like us to be.
Inflation still remains a problem, to be sure. The upshot of our present case, though, is that the Fed should be able to slowly tighten borrowing conditions and temper price increases, but also allow for continued economic expansion, obviating any need for drastic interest rate increases which bring down inflation at the expense of employment and growth.
Prevailing inflation will remain a problem for the near future, but we are not in the same situation as we were in the late ‘70s when the policy rate was much higher and cost-push inflation had become a self fulfilling factor of inflation expectations. The Fed has better knowledge of the actions it needs to take and has more effective tools at its disposal to address our present challenges. Drastic measures to fight inflation which result in high unemployment is nowhere near the central bank's policy playbook.