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With inflation surging to a four-decade high last month, pressure has increased on the Federal Reserve — often called the Fed — to take more aggressive steps to combat rising prices. The Fed is the United States’ central bank and oversees the nation’s monetary policy. Among other goals, the Fed sets a target inflation rate of 2% each year — far below current levels. Since March, the Fed has repeatedly raised the federal funds rate to combat surging inflation, including a 0.75% increase on Wednesday — the largest hike since 1994. Yet economists say that such rapid hikes could negatively impact economic growth and warn a recession might be on the horizon.
Combating Inflation
Inflation. According to Investopedia, “inflation is the decline of purchasing power of a given currency over time.” This means that one dollar cannot buy the same amount of goods or services as it could in years past. While moderate, steady inflation promotes spending and marks a healthy economy, rapidly rising prices are problematic. Currently, record inflation is straining Americans’ wallets, especially as groceries and gas prices continue to increase. Prices rose 8.3% from last year — the largest jump in the past 40 years.
Federal Funds Rate. The Fed plays a key role in moderating inflation primarily by changing the federal funds rate. The Federal Open Market Committee (FOMC) sets this rate for banks to borrow and lend money to one another. The federal funds rate has varied wildly, from a historic high of 20% in the early 1980s to near-zero levels during the Covid-19 pandemic. Following Wednesday’s hike, the target range is 1.5-1.75%. The Committee’s decision to raise this rate effectively makes borrowing more expensive for consumers and drives down demand. This reduced demand can lower prices.
Fed’s Economic Outlook. The 0.75% rate hike is a drastic step to rein in inflation, and Fed Chairman Jerome Powell said that he does not expect such increases to be common. However, the FOMC says it will continue to raise rates until it sees “compelling evidence” that prices are decreasing. Yet even amid the economic uncertainty, the Committee released a generally optimistic statement about the economy, touting an increase in overall economic activity, “robust” job gains, and low unemployment. It expects inflation to be substantially tamer next year, with its projections showing a 2.6% rate — slightly higher than its preferred target but a sharp decrease from its current levels.
Impact on Americans
Rate Hike Impact. The Fed’s rate hike will have ripple effects throughout the economy and impact American consumers in various ways. Concerns over how the Fed’s actions could weaken economic growth have already contributed to a volatile stock market, with stocks dropping notably and traders becoming more and more nervous. Its persistent increases will also drive up mortgage rates and loans without fixed interest rates — such as car loans and credit card debt. Consequently, financial analysts are encouraging consumers to pay off any debt that they currently have.
Lowering Prices. While the Fed plays a significant role in driving the money supply, impacting supply and demand and thus inflation, it does not have the tools to address many other factors contributing to rising costs, like clogged supply chains and labor shortages. Additionally, experts say the move will have a minimal impact on surging food and gas prices. While raising interest rates decreases borrowing and demand, it does nothing to address supply shocks in those markets, such as those created by Russia’s invasion of Ukraine and ensuing sanctions.
Looming Recession?
What is a Recession? A recession is a sustained period of significant economic decline. Analysts have traditionally measured it by two consecutive quarters (six months) of declining economic performance, though the modern definition considers other factors, such as increasing unemployment. Recent polls have shown many Americans are increasingly fearful that the U.S. is on the verge of a recession.
Doubts About a “Soft Landing.” In raising interest rates to combat inflation, the Fed has repeatedly asserted the idea of achieving a “soft landing” — a term economists use to describe a slowdown of growth that does not induce a recession. However, many economists are increasingly doubtful that the Fed will be able to reduce inflation without causing a downturn. If the Fed raises interest rates too quickly, they risk decreasing consumer demand too much and harming the economy, driving businesses to lay off workers. In the past five times that inflation peaked above 5%, a recession followed, raising doubts that the Fed can successfully tighten rising prices without inducing one this time.
