The Fed’s battle to fight inflation could cause more pain than rising prices

But some economists warn that would be a very bad idea, hurting the people the battle against rising prices is supposed to help.

“The people you recruit into the fight against inflation when you raise interest rates and slow the economy are the most vulnerable,” said Robert Reich, the former U.S. Secretary of Labor under President Bill Clinton and professor of public policy at the University of California, Berkeley. “The point of raising interest rates is to blow the sails of the economy. If it works, you are by definition going to have fewer jobs. Even small increases in interest rates, if they have desired effect, cause loss of jobs and loss of wages.”

Still, it’s clear that high prices are a major concern for many Americans. It is widely accepted that the Fed must act against inflation.

The history of rate hikes is cause for concern

The last time the Fed raised rates by half a point all at once was in May 2000. The labor market was exceptionally strong then. Unemployment had reached what was then a 30-year low of 3.8% by April of that year.

Although the consumer price index in March of that year was 3.8% – about half of what it is today – it more than doubled in the previous 12 months, raising concerns about inflation.

The Fed, which had raised its rates five times by a quarter point since the previous June, decided to be even more severe with a hike of half a point in May 2000.

The economy didn’t take it well.

Private sector employers, who had created jobs every month for the previous five years, suddenly cut jobs in May 2000.

They started creating jobs again for most of the rest of the year, but then started shedding jobs most months from the start of 2001 — losses that continued for three years. Many experts attributed the job losses to the bursting of the dot-com bubble, which occurred in the summer of 2000. But many job losses occurred in non-tech sectors such as construction, retail, automotive manufacturing and airlines.

The economy fell into recession in early 2001, and the Fed quickly cut rates half a point at a time in an attempt to pull the economy out of recession. Even though the recession was “mild” by economic standards, the jobless recovery that followed was not the idea of ​​a strong economy.

This is what worries so many critics of the war on inflation.

“Every time the Fed has tried to slow the economy by controlling prices, it has overstepped its bounds,” Reich said.

The Fed powerless to fight much of the inflation

A big concern for Reich and other critics of tighter monetary policy is the belief that much of today’s inflationary pressures come from things that rate hikes will do little to control.
Much of the rise in oil prices is due to geopolitical issues, such as the decision by OPEC+ countries to cut production when demand for oil plunged at the start of the pandemic. But demand came back faster than expected and supply did not keep up with that demand.
Prices in global commodity markets have risen more recently on fears that Russia, one of the world’s top oil producers, could invade Ukraine and face economic sanctions, further pushing up oil prices.

A 40% rise in gas prices alone has pushed the overall consumer price index up 1.5 percentage points over the past year.

Record car prices are another major factor, and these have been pushed higher by a shortage of computer chips and other parts, which has forced automakers around the world to temporarily halt production. The production cut affected both new and used car prices, and together these prices raised the headline CPI by around 2.2 percentage points.

Thus, 3.7 percentage points, or just under half, of the 7.5% increase in the CPI is due to the increase in the price of these three elements alone. gasoline, new vehicles and used cars.

“Most of the inflation we’ve seen over the past 15 months relates to the extreme distortions the pandemic has imposed on the economy,” said Josh Bivens, research director at the Economic Policy Institute, a group liberal thinking.

Rate hikes could affect the value of your home

One segment of the economy that the Fed can impact by raising rates is the housing market. This is another segment of the economy that has seen drastic price increases, with average home values ​​increasing by a record 16.9% in 2021. This has also impacted rents and pushed some buyers out of the housing market.

Rising mortgage rates will serve to rein in rising house prices, even as they continue to drive up the cost of buying a home.

The federal funds rate, which the Fed sets, does not correspond directly to most mortgage rates, but it influences the bond market, which does. Thus, anticipation of future rate hikes by the Fed has already started to drive mortgage rates higher, with a 30-year fixed-rate mortgage rising nearly a full percentage point over the past year to reach 3.69% according to Freddie Mac.

If these rates continue to rise, house price growth should slow or even decline. reverse. That would be good news for homebuyers, and possibly renters, but bad news for landlords. And that could slow consumer spending.

“Every time house prices go down, because [homes are] so much of the wealth, there is going to be a reduction in consumption,” Bivens said.

And there are other risks associated with falling house prices, including a drop in housing construction to alleviate a housing shortage in many markets. At the extreme, it was the bursting of a real estate bubble that caused the Great Recession. Most economists don’t expect this to happen again, but many discounted the possibility of a housing bubble bursting the last time it happened.

How fast can rates be safely increased?

When the pandemic hit, the Fed cut its federal funds rate by 1.5 percentage points to virtually zero. It has remained there ever since.

Many economists entered the year expecting the Fed to raise rates three or four times by a quarter point each time. Mounting inflationary pressures now have calls for a half-point increase upfront, and nearly 2 percentage points increase overall throughout the year.

Bivens isn’t necessarily opposed to the Fed starting to raise rates, but he would advocate doing so slowly with small quarter-point increases, and perhaps not at every meeting, as policymakers wait to see if pandemic-inflated prices return to normal.

“Reducing the level of aggregate demand by raising rates would be a machine gun approach to something that needs a scalpel,” he said.

Even some economists who would raise rates faster than Bivens agree it will cause economic hardship.

“The mechanism by which monetary policy tackles inflation is that it slows down the economy. It’s a very, very painful path,” said Justin Wolfers, professor of public policy and economics at the University. ‘University of Michigan. Still, he believes current rates are low enough, especially relative to the rate of inflation, to make rate hikes less risky than some past hikes.

But Wolfers says there’s a risk the economy will start shedding jobs, rather than just slowing the pace of job increases, once the Fed starts raising rates.

“What (Fed Chairman Jerome) Powell is hoping for is a so-called soft landing, creating a small number of jobs each month, and allowing the economy to go sideways and pick up. his breath,” he said. “There’s a long history in the United States and elsewhere of not getting these soft loans.”

– CNN’s Matt Egan contributed to this report

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