The Federal Reserve is fighting inflation with the first interest rate rise since 2018 and signals that six more rises are likely in 2022. Some critics say the long delay in seeing the inflation problem will make it difficult for the Fed to avoid a recession.—The Australian Financial Review
What was the U.S. inflation rate in 2022?
The U.S. inflation rate measured by the year-on-year percentage change in the CPI in February 2022 was 7.9 percent. Figure 1 shows how the inflation rate rose from a low of 0.2 percent in May 2020 to its high 2022 level.
How did the Fed respond to the economic fallout of the Covid-19 pandemic?
The Fed responded to the economic fallout of the Covid-19 pandemic by lowering the federal funds rate to 0.25 percent on March 16, 2020, and to 0.1 percent at the end of March. The Fed also launched a massive program of asset purchases of $50 billion per month, which swelled the monetary base to $4 trillion.
What actions must the Fed take to lower the inflation rate?
To lower the inflation rate, the Fed must raise the federal funds rate and begin selling assets to shrink the monetary base. These actions will trigger a monetary transmission process. Unfortunately, lowering the inflation rate occurs in the final stage of the transmission process and it is preceded by a slowing of the real GDP growth rate and a rising unemployment rate.
What is the likelihood that lowering the inflation rate will bring a recession?
The likelihood that lowering the inflation rate will bring a recession is high, and Figure 2 shows why. The graph shows the U.S. inflation rate since 1948 and the shaded bars show the recessions. Inspect the graph closely. Notice that, except for the 1950s, every period in which the inflation rate falls, it is either preceded by or accompanied by a recession. If the Fed lowers inflation to around 2 percent a year without bringing a recession, the Fed will do what it has been unable to do over the past 65 years.
How high must the interest rate go to lower inflation?
The historical record says that to lower inflation, interest rates must be raised to a level that exceeds the inflation rate. Figure 3 shows the federal funds rate since the 1950s. Based on the historical record, the Fed’s interest rate policy will either lower inflation and bring a recession (as occurred in 1980) or avoid recession but fail to lower inflation (as occurred in the 2000s).
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