The Fed Is Raising Interest Rates to Make Up For Its Own Inaction

“Natura non facit Saltus”– “Nature never leaps forward.” That is the motto that the great Victorian economist Alfred Marshall chose as the headline for Economic principles.

Until recently, “The Fed never takes the leap” may have been our central bank motto. With rare exceptions, when it raised rates, it did so in small steps of 25 basis points, or a quarter of a percentage point. But in May Federal Reserve rate increase 50 basis point for the first time since 2000, and it just lifts them backvia 75 fundamentals — a move not seen since 1994.

Why the leap? Of course, the immediate cause is inflationaryAccomplished some leaps of its own. After nearly a decade below the Fed’s two percent target, it spiked last spring and has been rising ever since. Over the past 12 months, the Consumer Price Index has increased by 8.6% – something not seen since 1981. So it’s a special move by the Fed.

But pointing to high inflation raises the question: How did the Fed let it go so high? And why is it now plunging without brakes, risking a catastrophic failure of the US economy, when it could have started pumping months ago?

Some blame it on “Quantitative Easing”—the large-scale security purchases the Fed started making when COVID-19 broke out. All that said, those purchases added about $1.6 trillion to banks’ cash reserves — an amount, some experts say, that would make lending by banks and prices skyrocket once things get better.

Once upon a time, that story would make sense. But everything changed in October 2008, when the Fed started paying interest on bank reserves. Now, to keep the banks from lending too much, the Fed just has to pay them more. So we’re going to ask why the Fed didn’t start raising rates sooner.

It’s messy for three reasons. The first is the Fed’s official misuse of “forward guidance”—its statements about the likely future direction of Fed policy. Used properly, such guidance can assure the public that the Fed plans to do what is necessary to keep policy on target. But the wrong kind of forward guidance can keep the Fed stuck on its own promises, forcing the Fed to choose between breaking its ostensibly pledge and keeping inflation on target.

That’s just the trap the Fed found last year. After COVID-19 broke out, Fed officials started saying they didn’t expect it to raise rates until 2023 or 2024. That “guidance” may have played a part in the officials’ decision. Fed on first shutdown after COVID. interest rate hike until this March. That is full ten months after inflation breached five percent — a rate that caused Richard Nixon to freeze prices and wages for the first time since World War Two.

The second reason is the new strategy of the Fed in controlling inflation. Stricken by persistently below-target inflation and complained that early, previous rate hikes led to unnecessary unemployment, in August 2020, Fed officials opted for a more conservative approach. new.

While their old strategy had been for the Fed to raise interest rates whenever inflation rose above its target, no matter how low it was in the past, under the new scheme, known as the “average inflation target”. flexible” (FAIT), it will allow inflation to rise above the long-term level. -Run the target long enough to make up for the previous missing shot.

But if the FAIT is good at keeping the Fed from getting too tight, it has proven capable of keeping it from getting too tight. The problem is the ambiguity of the new strategy. Fed officials have never said how far back they will be in deciding how much “offset” they intend to do. They also did not say how long it would take them to get inflation back on target. This lack of clarity makes it too easy for them to raise interest rates, despite high inflation numbers, while still claiming to be true. Worse, it means that Fed officials themselves can never be sure if they’re on the right track.

The third source of the problem is the output or supply “shock.” Generally speaking, prices can go up because people are spending too much – “demand-side” inflation – or because goods become scarcer – “supply-side” inflation.

It makes perfect sense for the Fed to ignore or “see through” inflation from the supply side: when goods become scarcer due to lockdowns, wars, sanctions, or any other decline in supply, Higher prices only reflect that sad reality. If the Fed keeps prices down by tightening credit, that will only add to the pain of combining the inevitable scarcity of goods with the inevitable scarcity of the means to pay for them.

In contrast, demand-side inflation is the fault of the Fed. Rather than mean that goods become scarcer, it simply means that money is too abundant.

The fact that a significant portion of recent inflation has been supply-side seems obvious. But how much? Fed officials have tried to gauge it by looking at the “core” inflation rate – a rate that lowers food and energy prices, especially subject to supply shocks. Because core inflation oscillates between 1 and 1.5 percentage points below “headline” inflation, Fed officials take it as an indication that inflation levels are “transient.” meaning it will disappear without any help from them.

But “core” inflation is a poor indicator of demand-side inflation. All prices are influenced by both supply and demand, so pick a few generally mostly depending on the end is hardly a reliable way to know how quickly demand for a commodity is growing. That kind of demand can be directly tracked by looking at Nominal Gross Domestic Product (NDP)—a direct measure of the total amount spent on output by the United States.

If Fed officials kept an eye on NGDP, as some economists have urged them to do for years, they would have every reason to start raising rates modestly late last year. And we’re all going to be a little less impatient now.

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