The Fed’s most often used tool for enacting monetary policy is manipulating the Federal Funds rate- this is the rate that drives what banks pay for money loaned to them (the Effective Rate). Raising this rate dampens intra-bank lending, limiting the funds available for banks to lend to consumers and businesses, thereby slowing growth by limiting the amount of capital spent on goods, services, hiring, and business investment. This action is primarily directed at the demand side of the equation and cannot directly address supply-side issues.
TAMING INFLATION
In simpler terms, inflation is either too much demand, not enough supply, or, as is usually the case, a combination of both. As mentioned, one of the effects of rate increases is limiting what businesses can spend on expansionary actions such as investing in equipment, technology, and workforce. As hiring slows, businesses can’t maximize revenues, returns are lower, wage increases are lower, and fewer people are employed. As the unemployment rate rises, less people have money to buy goods and services which slows the Gross Domestic Product (GDP) in turn. This is the “good news is now bad news” we previously referenced. While driving up unemployment is painful, it is nearly impossible to slow an economy and reduce inflation without doing so.
SETTING RATES
In September, the Federal Reserve raised the rate for the fifth time in 2022, with this current increase and the last three increases coming in at a rate of 75 base points or 0.75%. In five months, the actual/practical lending rate between banks (the Effective Rate mentioned earlier) has risen from 0.08% to 2.48%. The rate itself isn’t as shocking as the steepness of the incline. Rates were at 2.4% as recently as 2019, but to increase 2.5% in five months is extremely rapid and unprecedented in U.S. history.
SWIFT CHANGES
Our economy has what is known as the Neutral Rate. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability, therefore it is a theoretical balance point where monetary policy is neither accommodative nor restrictive. 2
The Federal Reserve desires to get beyond the point of neutral as quickly as possible because spending time above neutral secures price inflation into consumer’s minds and it becomes embedded inflation. Rate increases are coming quickly because once inflation becomes embedded, the Neutral Rate could increase. The Fed would then have to raise rates even further to get the desired result of reducing inflation.
Embedded inflation is the hardest to combat and is easiest to see in wage data. Wages are typically only set once a year, out into the future, and if inflation is “embedded” in the minds of the wage setters, you will see inflation built into the set wage and it will continue to be paid out into the future, with the only chance to bring it down coming a year later. Thus, prolonging the effects of inflation in the first place.
Of course, the best way to combat embedded inflation is to root it out before it becomes embedded. For a historical look at embedded inflation, look at The Fed in the late 1970s and into the 1980s. At that time, it took double-digit unemployment to rid the system of the effects of inflation. This matters to us today because we are facing a similar inflection point in the rate battle.
In our next article, we dig into the current recession indicators where we will likely see the effects of rate increases in the labor market soon. At that point, the economy typically sees rising opposition to maintaining an elevated rate environment, but the Fed will have to stay the course with higher rates to tame inflation. Accordingly, we will then see lower GDP and negative growth ripple through the system. Money and credit availability will be constrained, unemployment will be markedly higher, raw materials prices such copper, lumber, and plastics will trend down and consumer sales, the lion’s share of our economy, will be subdued.
Sources:
- Federalreserve.gov
- Dallasfed.org
