Interest Rate Hike: The Federal Reserve Declares War on Inflation (Op Ed)

By Desmond Lachman

Better late than never. On May 4, the Federal Reserve finally took decisive monetary policy action to regain control over inflation that has been largely of its own making. It also noted that it is highly attentive to inflation risks.

The Fed’s abrupt policy U-turn is good news in that it reduces the likelihood that we will return to the inflation of the 1970s. However, this does not mean that we will avoid paying a heavy price for the Fed’s past policy mistakes in lost output and employment.

Contrary to the Fed’s belief, the Fed must bear a large part of the responsibility for inflation’s recent surge to a forty-year high. To be sure, as the Fed claims, supply-side related problems associated first with the pandemic and then with Russia’s Ukrainian invasion have boosted inflation. However, it is highly doubtful that consumer price inflation would have reached 8 ½ percent without a highly accommodative budget and monetary policy stance.

One might well ask what the Fed was thinking last year when it kept interest rates at their zero lower bound and when it let the money supply balloon at its fastest pace in over 50  years at a time especially when the economy was recovering strongly and was receiving its most significant peacetime budget stimulus on record? One might also ask what the Fed thought when it continued to buy $120 billion a month in Treasury bonds and mortgage-backed securities throughout most of last year when the equity and the housing markets were on fire?

Today, recognizing that it had allowed itself to fall well behind the inflation curve and realizing that at $9 trillion, its balance sheet’s size has become overly bloated, the Fed has set itself on a path to make up for the lost time.

It has now taken the relatively unusual step of raising its policy interest rate by 50 basis points rather than the more standard 25 basis points. It has signaled that more such 50 basis point increases are expected at future Fed meetings. At the same time, it has committed itself to reduce its balance sheet size by $47 billion a month over the next three months and $95 billion a month over the remainder of the year. It will do so by not rolling over its extensive bond holdings at maturity.

If the Fed sticks to its program of meaningful interest rate hikes and balance sheet reduction over the remainder of this year, there would seem to be an excellent chance that we do not return to the inflation of the 1970s. However, there is reason to doubt that the Fed will succeed in pushing the inflation genie to the bottle without precipitating a nasty economic recession.

One reason for doubting that the Fed will succeed in engineering a soft economic landing is that there is no precedent for the Fed has done so when it has allowed itself to fall as far behind the inflation curve as it has done today. Larry Summers, the former Treasury Secretary under President Obama, correctly points out that never before has the Fed managed to squeeze four percentage points out of inflation, as the Fed needs to do today to get inflation back towards its 2 percent inflation target, without sending the economy into a recession.

The other reason for doubting that a soft economic landing is within the Fed’s reach is that it will have to raise interest rates to fight inflation in the context of equity, housing, and credit market bubble created by flooding the market with liquidity. As suggested by the equity market’s recent 15 percent slump since the start of the year in response to the Fed’s shift to a more hawkish monetary policy stance, there is a real risk that higher interest rates might be the trigger that bursts today’s asset and credit market bubbles. Should that indeed happen, we could be in for a tough landing.

Milton Friedman was fond of saying that there is no such thing as a free lunch. This is a lesson that the Fed might soon relearn as last year’s economic party gives way to a painful economic slump.

Originally published by American Enterprise Institute as “Interest Rate Hike: The Federal Reserve Declares War on Inflation It Caused.” Republished with permission.

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