Market Insights

The Fed Rate Hikes’ Effect on Inflation and the Economy

Gold Alliance disclaimer
What is the Fed doing now? And how will it effect inflation and the economy?

The Fed isn’t backing down. 

During his last scheduled talk before the Fed’s next policy meeting, Jerome Powell vowed to defeat inflation:  

“I can assure you that my colleagues and I are strongly committed to this project and we will keep at it until the job is done.”

In other words, as Barron’s reports: “Get Ready for Another Big Rate Hike.”

But can rate hikes beat inflation without sending the US economy into a recession? 

The New York Times warns, “If the Fed has to raise interest rates to painful levels … it could send financial markets tumbling, erasing stock and housing wealth.” 

And some economists believe massive interest rate hikes could trigger a deep recession. 

Others argue the Fed’s interest rate hikes don’t address the root causes of inflation, including supply-side constraints and rising commodity prices.  

Still, when asked if the Fed would do whatever it takes — even if it meant harming the economy — Fed Chief Powell made it clear: 

“I hope that history will record that the answer to your question is yes.” 

Will Powell follow Paul Volcker’s “rate shock” strategy? 

Former Fed Chief Volcker was as committed to defeating inflation in the 1970s as Powell is today. And in his autobiography, Volcker said he felt he had no other choice: 

“I suppose if some Delphic oracle had whispered in my ear that our policy would result in interest rates of 20% or more, I might have packed my bags and headed home. But that option wasn’t open.  

We had a message to deliver, a message to the public and to ourselves.” 

He delivered that message loud and clear by hiking interest rates to a whopping 20%. He also tightened the money supply through open market operations and higher reserve requirements for banks. And he implemented supply-side measures such as deregulation and trade liberalization. 

It worked. 

His strategy “shocked” inflation into submission. 

But it also sent the economy spiraling into two punishing back-to-back recessions.  

In fact, the 1981–1982 recession was one of the worst US downturns since the Great Depression. Unemployment peaked at 11%. Stock prices plummeted. And most other major asset classes fell off a cliff.  

But to Volcker, this was a necessary short-term sacrifice. He had to combat stagflation and bring inflation down from its peak of 14.8% in 1980. 

And he didn’t stop raising rates until it worked. 

Powell says he won’t stop either, so…

How is Powell fighting inflation?  

The Fed Chair’s approach is different from Volcker’s. He’s focusing on interest rates but shows no interest in controlling the money supply.  

During Powell’s testimony before Congress, Senator Kennedy expressed fear that spiraling money supply could lead to future inflation. Powell replied:  

“When you and I studied economics a million years ago M2 and monetary aggregates seemed to have a relationship in economic growth…Right now…M2…does not have important implications…so something we have to unlearn, I guess.” 

So, Powell is ignoring money supply. His sole focus is on interest rates, but… 

Will the Fed “keep at it,” even if it means hiking rates into the double digits? 

Powell acknowledges it won’t be an easy ride:  

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”  

Americans’ pocketbooks are already under pressure. And there are growing concerns about an imminent recession. So the pressure is increasing on Powell to slow down and even reverse his rate hikes. And some of the pressure comes from inside the Fed itself.  

Will Powell resist the criticism when the pain on households and businesses gets worse? 

And how much pain can we expect?  

Volcker used all the tools in his toolbox and still caused two recession. Powell is only using one tool. We’ll see if that’s enough.