The case for the Fed raising rates aggressively

The Federal Reserve will soon begin raising interest rates and the hot debate in economic circles is how fast the Fed should go. I side with those who believe that the Fed should aggressively increase rates, especially initially.

How high is up? At least to the pre-pandemic 2.50% high. The Fed should make a clear statement that it will do whatever it takes to keep inflation from becoming a longer-term problem. It can do that only by acting aggressively.

The current level of interest rates is not “normal” levels. They are emergency or crisis rates. That must be the starting point of any discussion about how far and how fast rates should be raised.

Let’s start with a little history. In 2007, just before the financial crisis hit, the Fed funds rate — the target interest rate that influences rates on consumer loans and credit cards — was about 5.50%. When the financial sector imploded and the world economy nearly collapsed, the funds rate was reduced rapidly to almost zero to help keep money flowing through the economy.

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The lingering effects of the financial crisis limited global growth, and rates were kept near zero for seven years.

By December 2015, the Fed determined that the economy had healed enough that rates could be moved slowly back toward normal levels. At the end of 2018, the funds rate had hit 2.50%. Then the pandemic hit, and rates were again slashed to zero and kept there.

Currently, a higher rate is possible because the 2018 economy was vastly different from the current economy in one very important way: Inflation then was in the 2% to 2.5% range, just about where the Federal Reserve wants to see it. Now, depending on the measure used, it is running two to three times faster.

Clearly, the Fed needs to act, but how fast should it go?

This is where the economics profession has its great divide. Some argue that the Fed should go slowly because the current inflation rate is being elevated by factors that will fade over time. Although inflation may remain elevated for an extended period, forces are already in place that will lead to an untangling of supply chain issues and a reduction of the excess demand that are the underlying causes of the spike in business and consumer prices.

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If that is the case, shouldn’t the Fed just ride out the storm by raising rates slowly? Not necessarily. The length of time it takes for the factors driving up prices to dissipate is crucial.

Inflation has exceeded the Fed’s 2% average target for a year now and it should continue to do so for the rest of this year. The Conference Board’s C-Suite Outlook 2022 noted that “59% [of respondents] expect elevated pricing pressures until mid-2023 or beyond. … In 2022, inflation is the 2nd top external concern. In 2021, it ranked 23rd.”

It isn’t just large companies that expect costs and prices to rise. The National Federation of Independent Businesses recently reported that 62% of the firms it surveyed increased their prices, the highest in nearly 50 years.

Higher prices are being built into corporate planning, which means they are beginning to enter inflation expectations.

In addition, most firms are expecting wage pressures to continue. Labor shortages are pushing up wages. In the latest data, average hourly wages rose at a 5.7% pace, compared with roughly 3% in 2018.

Rapidly rising prices and wages create the Fed’s greatest fear: rising inflation expectations that would require strong action to squelch.

So, what should the Fed do? In the current circumstance, there are two types of mistakes the Fed can make: Doing too much or not doing enough.

The Fed’s decision comes down to which mistake costs the economy less.

The Fed could move strongly by raising rates half a percentage point in March, and also indicating it could hike rates by an additional one or more percentage point over the remainder of the year. That would show that the Central Bank takes the inflation problem seriously and will do whatever is necessary to ensure high inflation does not become embedded in the system.

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The downside: The economy could slow rapidly and possibly go into recession. That would force the Fed to quickly cut rates, hoping to limit the damage.

The alternative is to move slowly and see how long the “transitory” inflation pressures take to fade. The economy should run hotter under this approach.

The risk is that inflation stays higher, longer, and becomes embedded in business and household decision making. That would force the Fed to eventually raise rates rapidly, likely to higher levels than if it had started by hiking rates sharply and quickly.

Which path to choose is a judgment call. To me, the greater risk is that inflation becomes embedded in the economy. Businesses and workers have pricing power they haven’t had in decades. I don’t expect them give it up easily or quickly.

The combination of extended wage and prices pressures would likely force the Fed to slow growth rapidly by jamming on the brakes. The resultant recession would be greater than might occur if the Fed initially raised rates too quickly.

Joel L. Naroff is the president and founder of Naroff Economics, a strategic economic consulting firm in Bucks County.