Given recent volatility in the markets, the Fed should have paused and waited for more data before pursuing more interest-rate hikes.
Instead of raising rates again today, the Fed should have paused.
A s the financial world continues trying to unpack what’s happened since the Silicon Valley Bank collapse, the Fed’s decision-making body for monetary policy, the Federal Open Market Committee (FOMC), has decided to again raise its target interest rate. The federal funds rate will rise another 25 basis points, or one-quarter percentage point, in an effort to bring inflation down to the 2 percent goal. Given recent volatility in the markets, the Fed should have paused and waited for more data before pursuing more interest-rate hikes.
As many readers already know, while the inflation surge of the past two years has several causes, the most important factor has been the Fed’s excessive expansion of the money supply. Initially, Fed officials thought the inflation would be “transitory,” largely reflecting supply-chain disruptions. In 2021, even as the economy showed strong signs of recovery and after Congress passed a massive fiscal stimulus, the Fed kept the federal funds rate at zero for the entire year. With inflation then breaking 40-year records, the Fed spent last year playing catch up and raised the federal funds rate 425 basis points (or 4.25 percentage points).
Although the Fed’s tightening was belated, inflation is finally trending downward. It would be easy to be misled by February’s Consumer Price Index, the most cited inflation measure, which rose 6 percent from one year ago. While this is clearly above the 2 percent target, it reflects past mistakes and is not necessarily a good indicator of where inflation is going next. The graph below shows the month-over-month growth of the CPI and the core CPI, which strips out volatile food and energy prices, from April 2021 to today.
While the two series do not move one-for-one, we can see that they generally move together. CPI growth peaked in June 2022 before most of the Fed’s rate hikes. It has noticeably fallen since then. Core CPI growth has been steadier, but it has also slowed since last year.
Even without the recent financial turbulence, we would have strong reason to believe inflation would keep falling. Monetary policy works with a lag, so we likely have not seen the full effects of the Fed’s previous rate hikes on the economy yet. Money growth, which is necessary for sustaining inflation, has fallen sharply. Global supply-chain pressures have eased. Breakeven inflation rates — market expectations of inflation — are hovering around 2.22 percent. Since breakeven rates are believed to slightly overstate inflation, they currently suggest future inflation will be around or even slightly below the 2 percent target.
Now, the American and entire global economy is grappling with possible financial crisis. Does that change things?
The shutdown and resolution of Silicon Valley Bank, the sale of floundering investment bank Credit Suisse, and the concern that other U.S. banks may be in trouble make the future especially unclear and signal the need for caution. We are already at the risk of recession if the Fed overplays its hand with interest-rate hikes. If the current turmoil does spiral into a larger crisis, a recession might follow.
It is worth recalling that for much of 2008, the Fed similarly faced a great deal of uncertainty, and it was just as concerned about inflation as it was about a stagnating economy. The Fed even refused to cut the federal funds rate after the collapse of the investment bank Lehman Brothers. In retrospect, the Fed’s decision proved to be a major blunder. Its failure to provide an adequately expansionary monetary policy that summer and fall greatly exacerbated the Great Recession.
By pausing now, the Fed would have been in a better position to address a full-blown financial crisis if one happens. It could have more quickly pivoted to an accommodative position. On the other hand, if the current volatility abates and high inflation remains, the Fed could have simply resumed interest-rate hikes later.
Although the Fed did not pause today, Chairman Powell and other Fed officials at least hinted that interest-rate hikes may soon be over. New projections suggest only one more interest-rate hike for the rest of the year. In their meeting statement, Fed officials also dropped a phrase from previous statements that “ongoing increases” would be appropriate for curtailing inflation. While it is good that the Fed is showing signs that it is “slowing down,” a more prudent choice would have been to wait for more certainty.
The Fed created the current inflationary mess by failing to adopt a more contractionary monetary policy in 2021 and 2022. Now it risks creating an error in the opposite direction.