The Federal Reserve’s Battle Against Inflation
9.1%: that was the headline rate of the Consumer Price Index (CPI), a key indicator of inflation for June 2022, the highest rate since 1981. Inflation, or the rate of price increases, is a key economic indicator; low inflation is important for a healthy economy to achieve stable growth. Since the 1980s, global inflation rates have become less volatile, in an era known as the Great Moderation. In the 2010s especially, the United States’ real problem was not really inflation but slow economic growth. However, everything changed during COVID. Factories shut down or were running at reduced capacity, and, while demand for goods jumped, demand for services dropped dramatically because people could not access them safely. The fall in supply and rise in demand resulted in goods inflation, and, as lockdowns ended, inflation for services as businesses like restaurants and hotels were understaffed.
This phenomenon divided economists into two sides: those who thought inflation was transient or would subside with time, and those who thought it would persist. The Federal Reserve, the US central bank, observing how global inflation rates had stayed low for the last 40 years, was on the transient side of the argument. They believed it could not be brought down using any traditional monetary policy like raising interest rates or quantitative easing. They argued this inflation was an issue from the supply side, and the Fed’s monetary policy can only influence demand, by encouraging or discouraging borrowing. Another factor that exacerbated inflation was energy prices, which jumped after Russia’s invasion of Ukraine cut off access to Russian oil and gas. Looking at the situation, it can seem that inflation was temporary, but some economists believed there was a risk that inflation could become de-anchored, or that people would begin accepting high inflation and preemptively raise their prices, creating more inflation. When inflation becomes de-anchored, it becomes much more difficult to get rid of.
As inflation stayed stubbornly high, even after the pandemic had ended, Fed chair Jerome Powell announced a .25% interest rate hike, which was significant as the first since 2018, and would theoretically cool off the economy by discouraging borrowing. However, inflation stayed persistently high, causing the Fed to engage in one of the most aggressive rate hiking campaigns in its history, raising interest rates by at least .50% in 6 successive months. To give context, the last time the Fed increased rates by that amount for 1 month was in March of 2000. The Fed’s goal is to move inflation back down to around 2%. The effects of these interest rate hikes have been widely debated; although general CPI has fallen from around 9% to around 4%, median CPI, which removes volatile assets to get a better indication of underlying inflation trends, only saw inflation fall from around 6% to 4.5%. That would demonstrate that the Fed has been ineffective at bringing down inflation, and its decline could be more tied to lower energy and commodity prices than their policies.
These rate hikes have also created problems in the financial sector, as higher interest rates contributed to falling bond prices. That created issues for banks holding them for interest, like Silicon Valley Bank, which failed and was brought into receivership by the FDIC, and First Republic, which was fire sold to JP Morgan Chase. However, the Fed has prioritized controlling inflation over everything else, and, after holding rates at 5.25% this month, it is expected to continue its rate-hiking campaign throughout the year, although at a somewhat slower pace.
