On Wednesday, the Fed officially raised its rate target by three-quarters of a percentage point, raising the rate it pays on reserve balances to 3.15 percent (up from 2.4 percent in July). As expected, most news reports look very bleak.
One headline announced that the Fed was raising interest rates to “reduce hyperinflation”. Another acknowledged that “the move was not surprising,” but still blamed the Fed for the stock market’s drop today because President Powell “strongly suggested that more big rate hikes are coming.” According to NPR:
The Fed ordered another big jump in interest rates today and signaled the possibility of additional rate hikes in the coming months, as it tries to rein in runaway rates.
Given Powell’s widely covered promise in August (delivered about a month later) to “Keep doing that until the job is doneIt’s very hard to see how anything in this week’s announcement was too surprising. However, the biggest problem with these types of reports is how they describe inflation and rate increases.
First, it is true that the price level is much higher than it was before the pandemic. However, journalists have demonstrated a stubborn tendency to focus on annual inflationary changes while ignoring month-to-month price increases.
It is the month-to-month changes that give a more accurate picture of where inflation is currently going. Changes from year to year tell us more about how the price level behaved last year. Yes, the price level could rise again in the future, but that is not the point.
Due to the price level rise that has already occurred, annual changes will remain high even when inflation begins to stabilize. In this case, very high.
But it would be nice if the growth is in the price level (especially, but not exclusively, as measured by the CPI) He seems to have calmed down. If this trend continues, it means that inflation has slowed down even though year after year Rate changes are still high.
As the close graph shows, if the monthly rate remains at 0.1 percent until August 2023, the annual inflation rate will not fall below three percent until May 2023. In other words, the price level (the gray line on the graph) is constant for a year Almost complete, but changes from year to year will still be above average because the initial rise was so high.
A key finding here is that the Fed does not have to bring the price level back to its pre-pandemic level for inflation to return to the 2 percent target area.
Fortunately, the Federal Reserve is familiar with this concept. It also recognizes that if you ignore this concept and instead tighten monetary policy so much that it brings the price level back to its pre-pandemic level, it is very likely to cause a recession. There is no compelling reason to try this route especially since over time income growth tends to keep pace with inflation. (This does not mean that the current episode is painless, but a massive contraction would be worse.)
A second recurring problem is how many journalists describe the rate of increase themselves.
It’s very hard to tell by just reading the news, but the Fed can’t set “interest rates” as it wants. In general, if the Federal Reserve tries to push prices above their equilibrium, the result will be the opposite: falling rates.
If, for example, the Federal Reserve tries to maintain abnormally high interest rates (at a level above the normal), it will lead to very tight monetary policy. That is, credit flows will dry up relative to market conditions that would otherwise produce.
As this excessively strict policy continues, everything else constant, total borrowing, aggregate spending, and the price level will fall. A decrease in the demand for credit will cause the federal funds rate to fall because lenders will have to lower rates to attract customers. (The same mechanisms apply if we focus, instead, on the wholesale funding aspect.)
More broadly, interest rates are determined by all kinds of global factors, from investors’ expectations to consumers’ saving habits. The Federal Reserve doesn’t control those factors.
A good example of this is the start of the Fed’s current tightening cycle. As I noted in March:
While everyone has been busy arguing about how boldly the Federal Reserve’s Open Market Committee should act, short-term interest rates have been busy imposing the committee’s hand. Three-month Treasuries stood at 0.05 percent in November, but expired in February at 0.33 percent. From February 1 to March 15, the rate on overnight non-financial commercial paper essentially doubled, rising from 0.16 percent to 0.33 percent. For one week, stock trading prices followed roughly the same path.
The Fed raised its target interest rate in March, after, after These market rates have increased.
It’s very easy to get hung up on what the Fed says about where it thinks rates should be in the future, but that’s even more important if you’re a bond trader. The rest of us must be skeptical about these predictions because they are based on changing conditions that are also difficult to predict.
Remember that in December 2021, the Fed’s average forecast for the 2022 federal funds rate was 0.9%, and real GDP growth for 2022 was 4%. In August, that median forecast was 4.4 percent for the federal funds rate and just 0.2 percent for gross domestic product.
I’m not referring to these shifts because they reflect how poorly the Fed’s outlook is. Nobody is particularly good at forecasting long-term economic data, especially when conditions are abnormal.
The point is that the Fed does not have strict control over prices or the broader economy. If it did, it wouldn’t have to adjust its forecast much, and there would be no reason to worry about whether the United States was headed into a recession.
All that said, there is a good argument to take a deep breath and relax.
The Fed raised its target rate by three-quarters of a percentage point three times in a row, and recent changes in the price level from month to month indicate that inflation is slowing. While the housing market is cooling, as expected with higher rates, broad financial conditions do not look too tight, and total commercial and industrial lending has continued to grow.
Therefore, the Federal Reserve can maintain its current course, without the “huge” increases in interest rates that would potentially lead to a recession. If inflation expectations remain constant – and There are indications that the Fed has succeeded on this frontThe Fed won’t have to go crazy.
Perhaps the best part is that journalists can help the Fed with forecasts. All they have to do is start giving more weight to the recent trend of the price level and stop expecting the Fed to do more than it really can.