The Federal Reserve just raised interest rates another 75 basis points This follows increases of 25 basis points in March, 50 basis points in May, 75 basis points in June, 75 basis points in July and 75 basis points in September. That totals an interest rate increase of 3.75% in eight months.
That is still not enough.
The purpose of these extraordinarily rapid rate increases is to remove enough demand from the economy to reduce record-high inflation. So far, the rate increases have not had an effect on inflation. Next week, the Consumer Price Index for October will be released. Since energy prices are rising, despite the best efforts of the Biden administration, the CPI number will likely be in the 0.5% to 0.8% range.
That means prices increases for the last 12 months will be in the 8.5% range or perhaps a bit higher, meaning that the Fed’s action has had little effect so far.
To be fair, it usually takes six months or so for monetary policy changes to impact economic activity. Most of the rate increases have occurred since June, so perhaps the rate increases may be sufficient. Or at the very least, the Fed can slow down the rate increases, which Chair Powell indicated may be the case.
Yet, after the next CPI number is released, coupled with a likely strong jobs report due out on Friday, the Fed will probably not back down. That means we can expect another 75 basis point hike next month.
While that will eventually reduce demand and reduce inflation, it may also cause a recession. The first two quarters of this year saw negative growth in gross domestic product (GDP), meaning that we just experienced a mild recession. The third quarter GDP number was a positive 2.6%.
That strong third-quarter GDP number will be interpreted by the Fed as an economy where growth has not yet been negatively affected by the interest rate hikes. Higher interest rates are needed, the Fed will reason, to reduce inflation while not appearing to harm growth, as yet.
The problem is that if the third quarter GDP number is closely examined, it will show real consumer spending and real business investment were falling. The positive GDP growth is due entirely to an increase in government spending and an increase in exports.
In the fourth quarter and moving to next year, government spending will slow as most of the stimulus money will have been spent. In addition, as US interest rates rise, foreign capital is attracted to the US bond market. That increases the demand for dollars, which will strengthen the dollar versus foreign currencies.
The strong dollar means our exports will be more expensive, which will reduce the demand for our exports and slow export growth. That adds up to a weakened US economy.
Still, the Fed must continue to be very aggressive with rate increases, even if it means the U.S. economy as well as the global economy goes into recession. That will bring the inflation rate down.
It is most important to have low inflation. High inflation negatively affects the entire population. A recession will have negative effects on only the portion of the population that becomes unemployed during recession. Fortunately, because of the severe labor shortage, the oncoming recession will see the unemployment rate rise by less than 1%.
That means this full employment recession hurts a much smaller portion of the population. High inflation gets embedded into the system and becomes very difficult to reduce, especially because of the resulting wage/price spiral.
President Reagan warned that inflation is a cancer. Once in the body, it spreads and damages other parts of the body. It must be removed quickly.
As I wrote in previous columns, the Fed must continue to be aggressive with rate increases. In 1981 the interest rates had to be raised higher than the inflation rate in order for inflation to fall. That may be the case here.