The Federal Reserve just announced the Federal Funds rate is raised by another 25 basis points, its the 10th increase since March 2022. While Fed officials have a goal to bring inflation down to 2%, they were somewhat unsure about raising rates further. Higher rates reduce the value of previously purchased government bonds, which could lead to more bank failures. They should have raised rates more.
After the shockingly irresponsible monetary policy which kept interest rates near zero all through 2021 and the first half of 2022, finally, in June 2022, the Fed got aggressive. Since then, rates have risen from near zero to over 5%. That is still not high enough to bring the inflation rate down to the Fed’s target.
As noted in prior columns, the Federal Funds rate will have to reach at least 6% before inflation will fall to the 2% Fed target. The danger with a rate that high is that the higher interest rates may reduce demand too much, so a recession would follow. And that is likely to happen.
Economic growth in the last half of 2022 was about 3%. In the first quarter of this year, growth slowed to 1.1%. Most likely economic growth will slow even more in the current quarter then turn negative for the last half of this year. That means the economy will be in recession.
The Consumer Price Index (CPI) for April will be released on May 10. It will likely show a monthly increase of 0.5% or 0.6%, which will increase the annual inflation rate for the first time since last June. The culprit will be rising energy prices.
The decrease in the annual inflation rate in the last half of last year was due mostly to falling energy prices, as the core rate (inflation excluding food and energy) stayed mostly constant in the 5.5% to 6.5% range. The core rate will continue to stay at that level. The rising energy prices that we have seen in the last month will lead to an increase in the CPI.
When the Fed meets again in mid-June, it will have the data from both the April CPI and the May CPI, which will show rising inflation, meaning it will likely raise rates by another 25 or 50 basis points. But if inflation fails to slow to the Fed’s target, another one or two rate increases may be needed. That will bring the Federal Funds rate to above 6%.
The first estimate for GDP growth for the second quarter of this year will be released at the end of July. The low growth or perhaps even negative growth will force the Fed to re-think its rate-raising policy. But since price stability is the Fed’s primary goal, they will continue to raise rates to the 6% level.
Some will argue that the Fed’s policy will make the recession worse and lead to 2 million job losses. That is probably true. But even if those workers lose their job, they will receive unemployment compensation, which minimizes their hardship. Meanwhile, the other 140 million households will benefit from reduced inflation and a higher standard of living.
The Fed made very serious errors in 2021 and into 2022 by increasing the money supply, mostly through their bond-buying program, and by keeping interest rates near zero. It erred again this past December and February when it stopped raising rates by 75 basis points. Instead, it raised rates by 50 basis points and then 25 basis points.
Had they raised rates by 75 basis points, the Federal Funds rate would be near 6% today. That’s what is needed to bring inflation down to the Fed’s target.
Fortunately, the recession will be mild compared to prior recessions. That’s because the current labor shortage will keep the unemployment rate much lower than is typically experienced during a recessionary period.
The faster the Fed can get the Federal Funds rate to 6%, the quicker inflation will be brought to an acceptable level. Recall at the end of 2020, the inflation rate was 1.4%. That’s where we would like to be. Everything in the economy works better with low inflation.
Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.
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