The Federal Reserve has significantly raised interest rates to reduce high inflation—but the real challenge for the central bank comes when inflation has been tamed.
- In the last 12 months, the Consumer Price Index rose 6%, which is high inflation but down considerably from peak inflation rates of 9.1% in June 2022.
- The Federal Reserve has responded to high inflation with nine consecutive interest-rate hikes over the past 13 months, raising rates to a range of 4.75% to 5%.
- The current interest rate does not reflect a historical record, with a peak of 20% in March 1980. The historical average between 1971 and 2023 has been 5.42%, with rates generally staying between 2% to 8%, according to Macrotrends.
- Rates reached a record low in December 2008 at 0.25%, and the past 15 years have marked a historic shift away from higher rates, generally staying below 2%, which leaves future rates unclear once the current wave of inflation crests.
Why It’s Important
The Federal Reserve Board and its Chair Jerome Powell have become household names over the last 18 months, as they have slowly turned up the dial on interest rates—leaving investors and business journalist churning through their every word, every decision, and rationale for any money move.
The Fed’s monetary tightening policies are purposely designed to slow the economy down. High-interest rates reduce liquidity, increase the cost of consumer debt, and decrease demand—thus, gradually reduce prices.
The Fed is playing a delicate game, manipulating an imprecise control that can produce sluggish results, Raymond James financial strategist Bill Dendy tells Leaders Media. The question is whether the Fed will overshoot its goal or land precisely where it wants to—maintaining its mandate to impact unemployment as little as possible.
“If inflation comes back down when everything comes under control, interest rates will presumably come back down too, and that will have the combined benefit of accessibility to funds and would be positive for the economy, creating new demand again,” says Dendy.
It’s at that point that the Fed retreats into obscurity—its monthly meetings and minutes followed by hard-core Fed followers, since interest rates often go years without moving if inflation is in check and the economy hums along.
The Future Of Fed Policy
Until then, analysts predict that the Fed’s inflation goal of 2% could be reached by late 2023, but there are no guarantees. When that does happen, the Fed will respond by lowering interest rates to a more manageable level. Ideally, Dendy says, the Fed will raise rates, aiming for 2% to 3% inflation—and will then reduce interest rates to 2% to 3% when it succeeds.
The Fed has faced severe criticism for its incorrect analysis of inflation trends and its reactionary approach to solving them. It initially declared that inflation was “transitory” and then rushed to increase interest rates after it realized it was wrong. The Fed could incur punitive political consequences if a Republican candidate wins the upcoming 2024 presidential election, as “Audit the Fed” movements are popular among conservative circles.
“The nation’s central bank, made up of a group of unelected experts, is coming under increasing pressure to go beyond its narrow mandate to achieve long-run price stability and maximum employment,” Cato Institute economist James A. Dorn writes. “Such intrusions into fiscal space and politics risk harming the Fed’s independence and credibility.”
Backing Up A Bit
In the 1970s and 1980s, the U.S. faced a similar inflation crisis to one that has been playing out since the end of the COVID-19 pandemic. But at a much different level. Inflation hit 12% and remained high for the better part of a decade.
“The Fed raised interest rates in the 1980s and saw similar challenges to now. The Fed has a unique mandate to control inflation and keep unemployment low. We’re liable to put up with some inflation or price instability to keep people employed. The Fed currently believes it has room for interest-rate hikes until unemployment increases,” says Dendy.
The current interest rate is higher than it has been since the 2008 financial crisis, but the ongoing stress is not a result of abnormally high rates. Keeping rates below 2% is a form of economic stimulus, which proved necessary during the Great Recession and the aftermath of the pandemic. The economy can handle high-interest rates and continue to operate, but the question for the Fed will be how much shock the system can take without breaking.
Red Flags To Decelerate
One of the clearest signs for the Fed that it has overextended itself is when key industries begin to self-destruct—and the Fed saw that already with the collapse of Silicon Valley Bank and other institutions, beginning March 10. The Fed responded by toning down its rhetoric that it would continue raising hikes multiple times before the summer, raising rates by just 25 basis points on March 22, compared to the multiple 75-point hikes last year.
“The Fed is running the risk of taking things too far—of derailing the economy with its aggressive stance against inflation. That’s a real battle, but if it goes too far, it’ll reverse decisions,” says Dendy.
Many Fed governors agree with outside critiques coming from business leaders like ARK Invest CEO Cathie Wood and Tesla CEO Elon Musk that the Fed is in danger of creating a deflation spike by overextending its policies. Economics is an imprecise science, and it is not always clear until after the fact to tell if policies have too severe an effect.
Positive Indicators Of A Soft Landing
Normally, positive indicators of change in this scenario would seem counterintuitive—meaning that high unemployment and low spending would be positive indicators that inflation is about to drop.
As we previously reported, the market has responded oddly to spiking interest rates. Inflation has gradually decreased but at a slow rate. But consumer spending has remained robust and unemployment is still historically low—two indications that the economy is more resilient than expected.
Dendy says this could signify that we can tame inflation and not send the economy into recession. However, there is no guarantee—as the inflation spike of the 1980s required nearly seven years to recover fully.