The Federal Reserve raised interest rates by three-quarters of a percentage point on November 2 and said fighting inflation will require further rises, yet at a slower pace in what has become the swiftest tightening of U.S. monetary policy in 40 years.—Reuters, November 3, 2022
What is monetary policy tightening?
Monetary policy tightening is raising the federal funds rate target to increase the cost of borrowing, cut aggregate demand, and eventually to lower the growth rate of nominal GDP and the inflation rate.
In what conditions does the Fed engage in monetary policy tightening?
The Fed engages in monetary policy tightening when the inflation rate rises and is forecasted to remain too high without action.
Figure 1 shows the rise in the inflation rate that triggered the Fed’s action.
How swift has monetary policy tightening been in 2022?
Very swift. In the seven months from April to November 2022, the Fed raised the federal funds rate from zero to almost 3.75 percent in six large steps.
Figure 2 shows that swift tightening following the gentle tightening that occurred between 2016 and 2019.
Over that three-year period, the Fed raised the federal funds rate from 0.4 percent to 2.5 percent in eight small steps to keep inflation inside its target range.
How does the 2022 tightening compare with those of the 1970s?
The interest rate increases of 2022 look small compared with those of the 1970s. Over the six months from February to August 1973, the federal funds rate rose from 6 percent to 10.5 percent, and over the seven months from August 1979 to April 1980, it almost doubled from 10.4 percent to 19.4 percent.
Figure 3 shows the federal funds rate in these three episodes of monetary tightening. The tightening of 2022 looks small in two dimensions. First, the overall increase is smaller at 3.75 percentage points compared to 4.5 and 9 percentage points. Second, the level is a long way below those of the 1970s at 3.75 percent compared to 10.5 and 19.4 percent.
There is another difference between 2022 and the 1970s: In 2022, the federal funds rate rises in steps as the Federal Open Market Committee (FOMC) announces its target level. In the earlier period, the Fed influenced the federal funds rate through its open-market operations. Federal Reserve History provides a brief account of the history of the federal funds rate.
Is the 2022 monetary policy tightening enough to conquer inflation?
No one, not even the FOMC, knows the answer to this question. But we can get some clues to the answer by looking at the outcomes of the earlier monetary tightening in the 1970s.
In February 1973, when Fed Chairman Arthur Burns started tightening, the inflation rate was 3.9 percent and the federal funds rate was 6.6 percent. Over the next six months, inflation climbed to 7.4 percent and the federal funds rate rose to 10.5 percent. Despite the rising interest rate, inflation soared and by the end of 1974, it had reached 12.2 percent. After raising the federal funds rate again to 13 percent in mid-1974, inflation fell to 5 percent but not until the end of 1976. On the road to lower inflation, the unemployment rate increased to peak at 9 percent in May 1975.
Notice the time lags: From the peak federal funds rate to lowering inflation to 5 percent, it took 29 months. At 10 months on this course, unemployment peaked at 9 percent. Also notice that throughout this tightening process, the federal funds rate exceeded the inflation rate.
In August 1979, when a newly appointed Fed Chairman Paul Volcker started tightening, the inflation rate was 11.8 percent and the federal funds rate was 11 percent. Over the next seven months, inflation climbed to 14.6 percent and the federal funds rate rose to 19.4 percent. Inflation then began to ease, but very gradually and remained at or above 10 percent until the end of 1981. Like in the earlier battle against inflation, as the inflation rate fell, the unemployment rate increased and reached a peak of 10.8 percent in November 1982.
Again, notice the time lags: From the peak federal funds rate to lowering inflation to 10 percent, it took 16 months, and to get inflation down to less than 3 percent. it took a further 20 months. Through this period of falling inflation, the unemployment rate kept rising and peaked at 10.8 percent. Also again, notice that the federal funds rate at 19.4 percent was raised by more than the rise in the inflation rate at 14.6 percent.
In April 2022, when Fed Chairman Jerome Powell started tightening, the inflation rate was 8.2 percent and the federal funds rate was 0.2 percent. Over the next seven months, as the federal funds rate was raised to 3.75 percent, inflation stabilized at around 8.5 percent.
Figures 4, 5, and 6 shows the paths of inflation and the federal funds rate before, during, and following the earlier episodes and a striking contrast between then and now.
If the time lags in the 1970s repeat in the 2020s, we can expect it to take many months before inflation falls. And through the period of falling inflation, we can expect the unemployment rate to keep rising. While many differences can occur between then and now, one striking difference might turn out to be crucial: In the 1970s, when interest rate increases eventually lowered inflation, the interest rate exceeded the inflation rate. In 2022, this gap is reversed.
If history repeats, inflation will not fall until the interest rate is raised to a level that exceeds the inflation rate. The data in Figure 6 suggest the Fed has a lot of heavy lifting to do.
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