The Federal Reserve is expected to announce its fourth rate hike of 2022 on Wednesday as it races to curb rapid inflation. The moves have many people wondering why rate hikes, which raise the cost of borrowing money, are America’s main tool to cool prices.
Sen. Elizabeth Warren, D-Massachusetts, wrote an op-ed in The Wall Street Journal on Sunday arguing that the Fed’s demand-crushing rate hikes are not the right policy to combat current inflation, as fuel costs and supply chain turbulence push up prices. The policies will hurt workers, he said, and “it doesn’t have to be that way.”
Others have argued that the Fed should remain dovish. Lawrence H. Summers, the former Democratic Treasury secretary, argued during an interview on CNN this week that the Fed needed to take “strong action” to control inflation and that allowing inflation to gallop out of control would be the ” bigger mistake” than causing a recession.
Viewers could be excused for struggling to make sense of the debate. Fed officials themselves acknowledge that their tools are blunt, that they cannot fix broken supply chains, and that it will be difficult to slow the economy enough without triggering an economic recession. So why is the Fed doing this?
The US central bank has for decades been what Paul Volcker, its chairman in the 1980s, called “the only game in town” when it comes to fighting inflation. While there are things elected leaders can do to combat rising prices—raise taxes to curb consumption, spend more on education and infrastructure to improve productivity, help struggling industries—these targeted policies tend to take time The things that elected policymakers can do quickly generally help mostly the edges.
But time is of the essence when it comes to controlling inflation. If price increases are rapid over months or years, people begin to adjust their lives accordingly. Workers could demand higher wages, raising labor costs and pushing companies to charge more. Businesses might begin to believe that consumers will accept price increases, making them less vigilant about avoiding them.
By making money more expensive to borrow, the Fed’s rate moves work relatively quickly to moderate demand. As buying a house or a car or expanding a business becomes more expensive, people pull back from doing those things. With fewer consumers and businesses competing for the available supply of goods and services, price gains may moderate.
Unfortunately, this process could come at a high cost at a time like this. Bringing the economy into balance when supply is tight—cars are hard to come by because of semiconductor shortages, furniture is back-ordered, and jobs are more plentiful than workers—could require a big drawdown of the demand. The slowing of the economy, which could significantly lead to a recession, leaving workers unemployed and families with lower incomes.
Economists at Goldman Sachs, for example, estimate that the probability of a recession in the next two years is 50 percent. Signs are already abounding that the economy is slowing as the Fed begins to raise rates, with headline growth data, housing market tracks and some consumer spending metrics showing a pullback.
But central banks believe that even if the risks are difficult to bear, they are necessary. A slowdown that increases unemployment would certainly be painful, but inflation is also a major impediment to many families today. Getting it under control is critical to getting the economy back on a sustainable path, officials argue.
“It is essential that we get inflation down if we are to have a sustained period of strong labor market conditions that benefit everyone,” Fed Chairman Jerome H. Powell said at his news conference last month.