Why the Fed announced the biggest rate hike in 28 years

The Fed is scrambling to get inflation back under control.
Why the Fed announced the biggest rate hike in 28 years
Financial conditions are tightening. (Photo by Stevepb)

The Federal Reserve took a dramatic step yesterday to get inflation under control, raising its target interest rate by 0.75 percentage points in a single day.

This was the largest one-day rate hike by the Fed in 28 years. And it represents a dramatic shift in strategy. Last month Fed chairman Jerome Powell seemed to rule out such a large hike.

The Fed announced a 0.5 percent interest rate hike on May 4. At a press conference following that meeting, Powell told reporters that a future 0.75 percent increase “is not something that the committee is actively considering.”

The Fed was hoping to see inflation start to come down from the March high of 8.5 percent. Instead, the Bureau of Labor Statistics announced last Friday that inflation had ticked up to 8.6 percent in May.

That triggered a significant fall in the stock market over the last few days, as Wall Street analysts anticipated that more aggressive monetary tightening would be needed to get inflation under control. By the time the Fed officials started their meeting on Tuesday, traders thought there was an 89 percent chance the Fed would raise rates by 0.75 percent, up from just a 4 percent chance a week earlier.

That left the Fed with little choice but to raise interest rates by 0.75 percent. Given market expectations, a half-point hike would have been seen as a dovish move and would have undermined public confidence that the Fed would get inflation under control.

“Inflation has obviously surprised to the upside over the past year, and further surprises could be in store,” Powell said at his press conference yesterday.

The change underscores just how tenuous the Fed’s position is right now. In normal times, even last month’s 0.5 percent hike would have been considered extremely hawkish. Now the Fed has been forced into an even bigger increase to keep inflation from spiraling out of control.

There’s a risk the Fed will overshoot and tip the economy into a recession. But there’s also a risk in the opposite direction: if the Fed tightens too slowly, it could damage its inflation-fighting credibility and allow inflation to become entrenched. In that case, inducing a recession might be the only way to bring inflation back under control.

The importance of expectations

I’ve written before that the Fed’s words often speak louder than its actions. That’s because monetary policy works largely by shaping expectations. If markets expect the Fed to raise rates in the future, financial assets will reflect those higher expected interest rates and that will slow the economy today.

That’s why last Friday’s higher-than-expected inflation number triggered an immediate fall in stock prices. A 0.1 percent higher inflation rate wasn’t going to directly harm any company’s bottom line. Rather, markets anticipated that the higher inflation figure would lead to faster Fed rate hikes. Higher interest rates, in turn, would discourage people from borrowing and spending money on cars, homes, and other goods. And that would slow down spending across the economy, which would hurt corporate profits.

Notably, the Fed didn’t have to actually do anything to trigger this chain of events last Friday. People knew that the Fed was committed to getting inflation back down to 2 percent. So when new data showed inflation wasn’t coming down, markets started “pricing in” faster rate hikes almost immediately.

The stronger a central bank’s inflation-fighting credibility, the more powerful this effect is, and the less the central bank actually needs to do to bring inflation under control. Back in the 1970s, the Fed kept monetary policy too easy for a decade, destroying its inflation-fighting credibility in the process. To regain that credibility, Fed Chair Paul Volcker had to raise short-term interest rates to nearly 20 percent in 1980, triggering the brutal 1981 recession.

We don’t seem to be at risk of that kind of outcome today. Markets currently expect inflation over the next five years to be about 3 percent—above the Fed’s 2 percent target, but nowhere near the double-digit levels of the late 1970s.

Still, I worry that the Fed isn’t taking inflation seriously enough. On Wednesday, the central bank released its quarterly Summary of Economic Projections, which shows policymakers’ predictions for inflation, unemployment, and other variables over the next few years. Fed officials expect the inflation rate to be 5.2 percent in 2022, 2.6 percent in 2023, and 2.2 percent in 2024.

Those last two figures would be a big improvement over the status quo, but I do wonder why they’re not lower. The Fed ostensibly has an “average inflation targeting” regime where it makes up for below-target inflation in one year with above-target inflation the next year. The Fed has said this regime is not symmetric, so nobody expects the central bank to deliver several years of actual deflation to make up for this year’s high inflation rate. But it does seem like the Fed should aim to deliver inflation of no more than 2 percent—and perhaps a bit less—in each of the next two years. If the Fed thinks its current policy won’t get inflation down to 2 percent in 2023, that seems like a sign that it’s not hawkish enough.

Of course, events beyond the Fed’s control, like the 2020 pandemic or this year’s war in Ukraine, could push inflation above 2 percent in 2023 or 2024. It may make sense for the Fed to ignore inflation to the extent it’s driven by these kinds of supply-side problems.

But there’s no particular reason to believe that supply-side problems will be worse in 2023 and 2024 than they are today—if anything, we might expect some improvement in the global supply chain over the next two years. So by projecting above-target inflation in 2023 and 2024, the Fed seems to be tacitly admitting that monetary policy is likely to be still contributing to above-target inflation more than two years in the future.

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