The Federal Reserve recently announced a further increase in the target federal funds interest rate to 3-3.25%. It is about slowing down the economy in order to reduce inflation. It’s a balancing act between the Fed’s two mandates – maximizing employment and containing inflation.
The pandemic necessitated stimulus policy to prevent the economy from imploding worse than it did. The Fed cut the fed funds rate to 0% and bought mortgage-backed securities to inject money into the economy, among other things. Various federal stimulus packages flooded household budgets with money to spend at a time when activities such as eating out or traveling were impossible or difficult. Once things opened, excess liquidity dramatically boosted demand even as COVID-19-related disruptions reduced supply. Add to that a war in Ukraine, a shutdown in China, a few weather disruptions and a labor shortage, and things only got worse (at least we’re not dealing with a workers’ strike). railways at this stage).
The most basic definition of inflation is that there are too many dollars for too few goods. We have started to see some improvement in the availability of goods (although there are still noticeable issues), but inflation remains stubbornly high. The good news is that, unlike the period of the late 1970s and early 1980s, the factors driving this inflation are not structural in nature and are not permanently embedded in the system. The bad news is that the near-perfect storm of factors that generated and sustained these increases is not dissipating as quickly as we would like, and liquidity and demand remain elevated. Some prices, like gasoline, have come down significantly and others are starting to stabilize, but so far that hasn’t been enough to move the needle without the added stimulus of monetary policy.
In response, the Federal Reserve has shifted from a cautious stance about disrupting the recovery to asserting that below-trend economic growth is acceptable if needed to bring inflation under control. In late August, President Powell declared that price stability was a central concern, acknowledging that higher interest rates, slower growth and the resulting easing of labor market conditions “would also be suffering for households and businesses”. He has since reinforced that message.
There is a legitimate sense of urgency in that if inflation becomes a perceived permanent condition, it can become a self-fulfilling prophecy. Such an outcome would make the specter of higher prices much harder to reverse.
President Powell pledged to “continue until we are satisfied that the job is done”. Despite some short-term pain, this is good news for all of us. The last thing we need is to create an inflation pattern that feeds itself into the economy. We have been there before.