To combat inflation, the Fed may move too aggressively on interest rate hikes
With some neck-snapping, an accumulation of economists and Fed experts have begun to argue that the central bank is now moving too strongly to slow the economy – and is overcorrecting for past mistakes. Many of the critics supported the Fed’s decisions just last year, when officials held off on raising interest rates to allow the labor market to recover as much as possible even as inflation rose.
The backlash has gained new ground as analysts cut forecasts for growth, the stock market falls and the lingering effects of the Fed’s previous rate hikes have yet to filter through the economy. Meanwhile, many of the world’s major central banks are raising interest rates at the same time, in a precarious economic experiment that has never been tried before.
“Managing the economy is like managing a large ship. It moves very slowly, and once you’ve seen the rudder return to normal, it continues, says Greg Mankiw, an economist at Harvard University and former head of the Council of Economic Advisers during the George W. Bush administration. Mankiw has joined a growing group of economists from the left and right who argue that the Fed is slowing the economy too hard. Mankiw said the Fed has obviously never been in this position before, but “it’s easy for a rookie to overreact, and if you turn too much in the other direction, that can be a source of instability rather than stability.”
Central banks seem to face new headwinds every week. A UN agency, the head of the International Monetary Fund and the World Trade Organization have all warned of a global slowdown as interest rates rise in major economies from Australia to Europe. A coalition of oil-producing nations led by Russia and Saudi Arabia announced last week that they would cut oil production, a move that will soon send gas prices back up. That decision came as President Biden and Western leaders have sought to keep oil flowing at lower prices as part of their response to Russia’s invasion of Ukraine.
The Fed has cut expectations for economic growth in 2022, and no one knows how long it will take for the slow effects of the rate hikes to take full effect.
“The Federal Reserve has been tightening policy sharply to bring down inflation, and US tightening is being reinforced by simultaneous foreign tightening,” Fed Vice Chairman Lael Brainard said in a speech on Monday. “We are starting to see the effects in some areas, but it will take some time for the cumulative tightening to pass through the whole economy and bring inflation down.”
Major stock indexes have fallen as Wall Street panics over the Fed’s promise of more rate hikes, plunging nearly 3 percentage points on Friday after the latest jobs report showed the labor market still hasn’t cooled significantly — another sign the Fed is unlikely to ease soon. Major indexes fell slightly on Monday as well, with the Nasdaq composite hitting its lowest level in two years, dragged down by falling technology stocks.
Yet, unlike other parts of the economy, central bankers does not specifically aim to cool down the stock market. In recent weeks, officials have said the wild swings are not their shape decision making. Stocks have been volatile in response to nearly every economic indicator.
“I’ve recently read some speculation that financial stability concerns could possibly result [Fed’s policy committee] to slow rate hikes or stop them earlier than expected, Fed Governor Christopher Waller said in a speech last week. “Let me be clear that this is not something I consider or believe to be a very likely development.”
As we enter the final stretch of the year, the Fed’s campaign to cut inflation could undermine the economy’s remaining strengths. The labor market is cooling in some areas, but has generally remained resilient through tighter monetary policy, with employers adding a solid 263,000 jobs in September. The number of job vacancies plunged by more than 1 million in August, an encouraging sign for Fed officials who aim to bring the number of job vacancies more in line with the number of people looking for work. Until now, there have been about two openings for every job seeker, although this number is slowly decreasing. Both consumption and personal income rose in August, and consumer confidence picked up as gas prices fell through the summer.
But Fed officials say they are laser-focused on inflation and see no reason to stop pushing interest rates up just yet. Central bankers are expected to raise interest rates by 0.75 percentage points at their November meeting, and by 0.50 percentage points in December.
Officials say their decisions will depend on the data. The September jobs report, which showed continued growth, is not expected to change their plans, as the labor market remains volatile and unemployment remains high. New federal inflation data to be released on Thursday could influence those decisions, although officials say they need to see months of clear and consistent progress on falling prices. That litmus test is far from being met.
“Reports in recent months have shown that high inflation is stubbornly persistent, while the labor market has remained strong,” Fed Governor Lisa Cook said in a speech last week, ahead of the September jobs report. “As a data addict, I have revised my assessment of persistently high inflation.” She noted that she “fully supported” the Fed’s decision to push interest rates up earlier this year.
The Fed kept interest rates close to zero for much of the pandemic, even as inflation rose. Since March, there has been a rush to get interest rates into “restrictive territory”, where they are actively slowing the economy. The bank raised the interest rate by 0.75 percentage points for the third time in September, bringing the benchmark interest rate to between 3 percent and 3.25 percent, higher than it has been since 2008.
But interest rate increases do not provide immediate clarity. That reality has inspired growing criticism from liberal lawmakers and Fed watchers who say the inflation battle ultimately involves wrong target. Interest rate hikes stop demand in the economy, but they do nothing to fix supply-side problems, such as shortages of oil and gas, affordable apartments or chips for new cars.
Some inflation may come down on its own as supply chains settle and the pandemic continues to ease. But after months of central banks a rising demand, companies can stop hiring and lay off people well before the cost of rent or gas prices or new cars fall, critics say.
“This idea that we take global supply shocks with domestic interest rate policy is probably not going to age well,” said Lindsay Owens, executive director of the Groundwork Collaborative, a progressive group that focuses on economic policy.
Owens compared the risks associated with the Fed’s approach to a frog sitting in a pot of gradually boiling water: “You don’t know you’re boiled until it’s over,” she said.
The Fed’s tools may be limited, but the job is both to keep prices stable and create a strong labor market. Officials say that if they don’t raise rates enough now, inflation will only worsen and force the central bank to act more aggressively later. The bank also appears to calculate that the labor market has been strong enough to bear the costs of bringing prices back to normal.
Officials have warned of financial pain to come. And that means that even when it bubbles up – in the stock market or people’s wallets – they won’t fluctuate.
“It’s far too early to make that call,” said Douglas Holtz-Eakin, president of the conservative American Action Forum and former director of the Congressional Budget Office. “What you’re hearing are voices from Wall Street who have lived on easy money for a decade. And I’m sorry, times have changed. My message is: Grab it.”
