The Federal Reserve will soon begin raising interest rates and heated debate in economic circles is how fast the Fed should go. I’m on the side of those who think the Fed should hike rates aggressively, especially at first.
What is the height ? At least up to the pre-pandemic level of 2.50%. The Fed should make it clear that it will do everything in its power to prevent inflation from becoming a longer-term problem. He can only do this by acting aggressively.
The current level of interest rates is not a “normal” level. These are emergency or crisis rates. This should be the starting point for any discussion of how much and how quickly rates should be raised.
Let’s start with a bit of history. In 2007, just before the financial crisis hit, the federal funds rate – the target interest rate that influences consumer loan and credit card rates – was around 5.50%. When the financial sector imploded and the global economy nearly collapsed, the funds rate was quickly reduced to near zero to help keep money flowing through the economy.
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The lingering effects of the financial crisis have limited global growth and rates have been kept close to zero for seven years.
In December 2015, the Fed determined that the economy had recovered enough that rates could be slowly brought back to normal levels. By the end of 2018, the funds rate had reached 2.50%. Then the pandemic hit and rates were reduced to zero again and stayed there.
Currently, a higher rate is possible because the economy of 2018 was very different from today’s economy in a very important way: inflation then was between 2% and 2.5%, roughly where the Federal Reserve wants to see it. Now, depending on the gauge used, it spins two to three times faster.
Clearly, the Fed needs to act, but how fast should it go?
This is where the economics profession has its big divide. Some argue that the Fed should go slow because the current inflation rate is elevated by factors that will fade over time. Although inflation may remain elevated for an extended period, forces are already in place that will lead to an unraveling of supply chain issues and a reduction in excess demand which are the underlying causes of the surge. business and consumer prices.
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If so, shouldn’t the Fed weather the storm by slowly raising rates? Not necessarily. The time it takes for the price-raising factors to dissipate is crucial.
Inflation has exceeded the Fed’s average target of 2% for the past year and should continue to do so for the rest of the year. The Conference Board’s C-Suite Outlook 2022 notes that “59% [of respondents] expect high pricing pressures through mid-2023 or beyond. … In 2022, inflation is the 2nd external concern. In 2021, he ranked 23rd.
It’s not just big companies that expect costs and prices to rise. The National Federation of Independent Businesses recently reported that 62% of businesses surveyed had raised prices, the highest in nearly 50 years.
Higher prices are being built into business planning, which means they are starting to enter into inflation expectations.
Additionally, most companies expect wage pressures to continue. Labor shortages drive up wages. According to the latest data, the average hourly wage increased at a rate of 5.7%, compared to around 3% in 2018.
Rapidly rising prices and wages create the Fed’s greatest fear: rising inflation expectations that would require aggressive action to quell.
So what should the Fed do? Under the current circumstances, the Fed can make two kinds of mistakes: overdoing it or underdoing it.
The Fed’s decision comes down to which mistake costs the economy the least.
The Fed could act strongly by raising rates by half a percentage point in March, and also indicating that it could raise rates by an additional one or more percentage points during the rest of the year. This would show that the Central Bank is taking the inflation problem seriously and will do whatever is necessary to ensure that high inflation does not embed itself in the system.
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Disadvantage: the economy could slow down quickly and possibly enter a recession. This would force the Fed to cut rates quickly, hoping to limit the damage.
The alternative is to move slowly and see how long the “transitional” inflationary pressures take to subside. The economy should turn warmer under this approach.
The risk is that inflation will stay higher, for longer, and feed into corporate and household decision-making. This would force the Fed to eventually raise rates quickly, probably to higher levels than if it had started by raising rates sharply and quickly.
Which path to choose is a judgment call. For me, the biggest risk is that inflation becomes entrenched in the economy. Companies and workers have pricing power they haven’t had in decades. I don’t expect them to give it up easily or quickly.
The combination of prolonged wage and price pressures would likely force the Fed to quickly slow growth by tightening the brakes. The resulting recession would be larger than what might occur if the Fed initially raised rates too quickly.
Joel L. Naroff is President and Founder of Naroff Economics, a strategic economic consulting firm in Bucks County.