Five reasons the Fed is playing catch-up

They took too long to fight inflation. Here are their best excuses.

Photo by the Federal Reserve.

The Federal Reserve announced Wednesday that it would increase interest rates by a half percentage point. This is an unusually forceful move by the central bank, which typically only hikes interest rates in quarter-point increments.

The Federal Reserve hikes interest rates (technically, it targets the short-run interest rate for banks lending to each other) when it believes there is too much spending in the economy⁠—too many dollars bouncing around bidding on goods and services and raising their prices.

Raising rates reduces that spending pressure by increasing interest rates throughout the economy. For example, car buyers might get less favorable interest rates on their car loans and spend a lower amount at the dealership. Or investors might take advantage of high rates and park their money in government bonds in lieu of a project that might help stimulate the economy.

While economists sometimes disagree about how to define the right amount of spending (and therefore, what would constitute “too much”) this is a relatively clear-cut case. Inflation is at a 40-year high. Spending has not only recovered from the pandemic, but even exceeded the pre-pandemic trends for months in a row. “They are strikingly behind,” Stanford economist John Taylor told the Wall Street Journal last month.

The Federal Reserve’s half-percentage-point hike suggests it has come to agree, and is moving double-time to play catch-up and get inflation under control. Here are five reasons why the central bank fell behind, and why this quick turnaround is what the economy needs.

1. It’s easier to fall behind when things are moving fast

The simplest reason the Fed is behind is that this recovery is moving much faster than other recoveries in recent memory. Dollars are moving around quickly, spurring both job gains, which are welcome, and inflation, which is not. This isn’t an unusual combination, but the sheer pace of the recovery has made it hard to react quickly.

For example, consider the unemployment rate. After unemployment peaked at 14.7 percent in April 2020, it took just 20 months to fall back below 4 percent. Prior recoveries moved much slower than this. For example, after unemployment peaked at 10 percent at the end of 2009, it took about eight years for unemployment to fall below 4 percent. The 1992-2000 boom also took eight years to bring unemployment below 4 percent. This recovery is about four times as fast as previous ones.

Or consider inflation. The consumer price index (CPI) increased 8.5 percent in the 12 months ending March 2022, with 1.2 percentage points coming in March alone. This was a relatively sudden development. Back in December 2020, inflation was just 1.4 percent over the prior 12 months, with just 0.2 percentage points coming that month.

This sort of dramatic acceleration is unusual in the United States. During the 2010s, inflation stayed close to 2 percent for a full decade.

The fast recovery was powered by the rocket fuel of deficit spending supplied in a series of fiscal packages. Two of them came in 2020 from bipartisan votes under the Trump administration. The third was enacted by a Democratic Congress under the Biden administration. It was also spurred by a kind of whiplash in consumer behavior⁠; consumers were cautious in 2020 and withheld much of their normal spending, but after vaccines mitigated the COVID-19 pandemic, they returned to spending freely.

2. It was hard to predict when people would spend down their pandemic savings

The pandemic allowed many Americans to build up dragon hoards of savings. In normal years, like 2019, you’d expect Americans to save about $1.2 trillion. But during the pandemic, many people couldn’t do usual activities, like going to restaurants, so they saved that money instead.

Ordinarily this would cause a drop in restaurant-owner and restaurant-worker income, but those who lost their jobs or businesses were helped by Congress’ relief bills. All in all, personal income was sustained, but people saved about double the usual rate in 2020 and 2021.

This left them with about $2.7 trillion more in accumulated savings than one might expect if pre-pandemic trends had continued. This created a problem for the Fed: They had to predict whether Americans would continue with relatively reserved, socially distanced, low-spending behaviors, or move on to an aggressive post-pandemic spending binge. Today we are closer to the latter behavior⁠—but it wasn’t clear beforehand exactly when that would start.

3. The Fed was fighting the last war

A lot of people in economic policy feel the 2010s recovery was too slow, and that we could have sped it along. I sometimes call this “2010s regret.” Among the officials feeling 2010s regret is Fed Chair Jay Powell himself, who reversed some of the Fed’s late-2010s rate hikes, and admitted under questioning from Congress that “the economy can sustain much lower unemployment than we originally thought without troubling levels of inflation.”

The misery of the 2010s was mostly felt by people searching for new jobs. The job market was weak because people felt cash-strapped, which made it hard for businesses to sell their products—and hence to hire more workers. If you had something to sell⁠—even if it was a useful skill or a good product⁠—people didn’t want it or couldn’t afford it. If you had money, you could spend it fine, but a lot of people were short on cash.

When the COVID-19 pandemic hit, many people, myself included, were worried about a repeat of this unvirtuous cycle. We worried people would lose income or jobs and stop spending money, resulting in lower incomes and lost jobs for other people.

So the Fed erred on the side of looser monetary policy. Loose policy⁠ can help fix such problems by making money, spending, and income more plentiful. But with the series of fiscal stimulus packages, the Fed’s chosen policy⁠—maintaining zero interest rates into 2022⁠—was overkill. Income had been preserved enough through fiscal policy.

4. It was easy to reach for convenient excuses

In early 2021, you could plausibly explain away the early signs of inflation as “supply-side” issues⁠. There were tangible reasons that semiconductor chips or automobiles were hard to come by, which made them expensive. While this is inflation, it’s not the kind of inflation that the Fed is tasked with handling.

Instead, the Fed is supposed to hold its fire unless it sees too much overall spending⁠. And in early 2021, the evidence of that was relatively weak. Spending was about on its historical trend⁠—though rising⁠. Prices were normal, and a few key pandemic-affected categories accounted for the bulk of inflation.

The White House’s economic advisors published an analysis of inflation in April 2021. At the time, pent-up demand⁠ from the extra hoard of savings was third on the list of causes, behind statistical quirks and pandemic-related disruptions. From time to time, the White House would post charts showing how inflation was pushed up mostly by pandemic-affected categories.

I don’t think this analysis was wrong at the time⁠—the early inflation really was driven by primarily by supply-side issues and data quirks. But by late 2021, spending really had exceeded pre-pandemic trends. This was demand-side inflation, the sort that the Fed really should respond to. Nonetheless a narrative that inflation was the result of pandemic-related problems outside of the Fed’s control endured for several months longer than it should have.

Today, the Fed’s statements note “broader price pressures” in addition to pandemic-related disruptions. That’s an acknowledgement that inflation isn’t just pandemic-related disruptions; economy-wide spending is too high.

5. A fight over Powell’s reappointment may have slowed the response

During the critical late-2021 moment when demand-side inflation truly began to take off, Democrats were in the midst of a big fight over whether to reappoint Jerome Powell⁠—a Republican, but a moderate one prone to bipartisanship, and one who had been effective at pursuing the kind of full-employment agenda that President Biden had campaigned on. Powell was ultimately reappointed in November.

Randal Quarles, another Republican Fed official who was not reappointed by Biden, offered an opinion that this fight may have slowed the response. “We would have been better served to start getting on top of [inflation] in September,” he told Rob Blackwell in an interview on the Banking with Interest Podcast. “That was hard to do until there was clarity as to what the leadership going forward of the Fed was going to be.”

This sounds political, and perhaps there are some sour grapes⁠—but it also might not be. Federal Reserve officials usually like to communicate plans several months in advance and then commit to them. It would have been difficult for Powell to commit to a plan without knowing he’d be there to follow through on it⁠. And it might have put his successor in a tight spot if he planned out a series of rate hikes on his or her behalf.

But now the coast is clear⁠—Powell was given a second term. And it’s important to get on top of inflation quickly, because as it becomes expected⁠, it starts a self-perpetuating cycle. Real interest rates are equal to nominal interest rates minus inflation. So if inflation gets very high, or higher than usual, the real federal funds rate actually falls. So even if the Fed stands pat, or raises interest rates slowly, it can actually be loosening policy⁠—and making inflation even worse.

The longer the Fed waits, and the slower they move, the more they have to raise rates just to make up for this effect. They are aware of these challenges, and that’s why they are hiking rates twice as fast as usual. But given the deeply unusual circumstances of the COVID-19 recovery, it’s hard to know whether such a move is too much⁠—endangering the recovery and risking a recession⁠—or too little. Powell was asked about three quarters-point hikes, and ruled them out thus far. But further high inflation might mean that even this week’s aggressive rate hike isn’t aggressive enough.