Federal Reserve Chair Jerome H. Powell unnerved investors when he said last week that the economy would likely feel some pain as the Fed raised interest rates to bring inflation down.
The Fed fights inflation through higher interest rates. It has hiked its baseline rate, the federal funds rate, from close to zero in March to 2.25 percent to 2.50 percent today. It has signaled that it intends to keep raising that rate until it sees consistent evidence that inflation is abating. Market-watchers now expect the federal funds rate to reach 3.8 percent by early next year.
That’s bad enough, but historical data show this is still likely to be much too low to reduce inflation. The United States faced six periods of rising inflation between the late 1960s and 2008. In each case, the effective fed funds rate was raised until it was higher than the inflation rate.
In the early 1980s, the nation faced its worst inflation in decades. Under Fed Chair Paul Volcker, the central bank hiked rates until they reached a peak of 19.1 percent in mid-1981. The consumer price index, which had peaked at 14.8 percent in March 1980, was still rising by more than 11 percent a year before it started a precipitous decline.
Volcker killed the inflationary spiral, but at a big price. Unemployment hit 10.8 percent by November 1982, the highest level since the 1930s. But the economy quickly recovered as inflation plummeted. By November 1984, inflation had dropped to only 3.9 percent and the unemployment rate was 7.2 percent and dropping. Voters rewarded President Ronald Reagan with a historic landslide reelection.
This pattern has recurred in every other significant inflationary bout in the past five decades. The effective federal funds rate exceeded peak inflation by between 1.8 and 4.4 percent in the five notable inflationary periods since 1970. In each case, the rate hikes triggered a recession and hiked unemployment. Inflation always declined and the economy recovered, but without significant pain.
Today’s inflation rate is significantly higher than the federal funds rate. Even through overall inflation was zero in July, the CPI was still 8.5 percent higher than the year previously. More ominously, core inflation — which is the rate for everything except food and energy — was still trending up by 5.9 percent in July. That rate would have to drop rapidly to prevent the Fed from driving up rates to levels not seen since the late 1990s.
It’s likelier that the Fed will have to keep raising interest rates well into 2023. The central bank is currently moving the rate up in chunks of 75 basis points — three-quarters of 1 percent. If the increases continue for the three meetings left this year, the Fed funds rate will still be less than 5 percent. Historically, that’s nowhere near enough to bring persistent inflation down.
That means that we should expect the Fed to hike rates much higher than currently anticipated. The Fed could additionally raise rates more quickly, perhaps increasing them by 1 percent or more at each of their next few meetings. That would bring them to 5.25 percent by year’s end, and perhaps to 8 percent by mid-2023. Such a level would still be below the level past Feds have had to reach to bring down a 9 percent inflation rate, but maybe the pandemic’s influence means things are different this time.
It is easy to imagine the fed funds rate reaching north of 10 percent by December of next year. That level would shock investors and policymakers, but would be in line with what historically has been needed to curb high inflation. This would almost certainly trigger a significant recession, with an end to tight labor markets and significant increases in unemployment. A recession would also damage President Biden’s political standing as the country heads into the 2024 election.
This outlook means that it would be much better for Democrats if the Fed brings the pain sooner rather than later. Rapid, steep rate hikes in early 2023 could halt inflation sooner, giving the Fed room to begin cutting rates in an election year. It would have been better politically for Biden if the Fed had started to seriously fight inflation last year. But that didn’t happen, and it would be best if the Fed did what is necessary as soon after the midterms as possible.
The dream of a soft economic landing from the pandemic is likely just that: a dream. Recovering from the global economic shutdown that covid created is more likely to be a nightmare.