Fed Chair Jerome Powell held a press conference yesterday to announce the Federal Open Market Committee’s (FOMC) decision to raise the primary credit rate to 1.75%. This is an increase of 0.75% from the rate in place since May.
This is important because a higher rate discourages banks from borrowing money from the Fed and, therefore, tries to reduce the amount of money they have available to lend elsewhere. The full press release can be read here.
One of the main goals of increasing this interest rate is to decrease the supply of money in the economy. Why would the Fed want to do that? Money is like any other commodity in that, the more supply that exists in a market,
the lower the price of that commodity. In contrast, the less of a commodity that is available in a market, the more expensive it becomes. We see this in action with oil and other well-known commodities but we don’t tend to think of money in this way. Every time you buy something though, you are exchanging a commodity that has value (currency) for something else that has value (goods or services). Inflation means you have to use more dollars to pay for the stuff you want to buy (i.e. the price of
the goods and services increases) because each dollar is decreasing in value. Inflation is a normal fact of life but it's the high rate of inflation recently that is the problem. More on this phenomenon can be found in our firm’s Client Academy video series here.
In theory, decreasing the dollars in circulation (the money supply) is supposed to increase the value of the remaining dollars still in circulation (or at least slow the rate at which they are devaluing). This is one part of
the Fed’s strategy for combating high inflation in our country. This rate is also important because it indirectly affects the interest rate banks and other lenders charge on a wide range of loans including credit cards, mortgages, auto loans and business lines of credit. They are all linked and all are expected to continue rising for the foreseeable future.
Yesterday’s announcement was important because the announced rate increase of 0.75% was in contrast to the FOMC’s statement during the May meeting (found here) that they were planning to continue with 0.50% increases going forward. Chairman Powell indicated that the FOMC’s reason for the more aggressive rate increase was in response to data released on June 10, 2022 that the Consumer Price Index (a broad measure of inflation) rose 8.6% over the preceding
12 months. This was the highest rate of increase since the 12-month period ending December 1981 (https://www.bls.gov/news.release/cpi.nr0.htm).
Here are my takeaways from Chairman Powell’s comments:
- Even with a 0.75% rate increase, we are still not in a “restrictive” monetary policy environment by any means. Chairman Powell indicated a Fed Funds rate of 2.50% would be considered “neutral” in which monetary policy was neither accommodative nor restrictive. We still have multiple rate increases ahead
before we are even in neutral policy territory.
- Chairman Powell indicated the FOMC is targeting a rate between 3.0% - 3.5% by the end of 2022 and 3.5% - 4.0% by the end of 2024, after which they anticipate rates coming back down toward their long-term target of 2% - 2.5% over some period of time (to be determined). They are going to continue monitoring the
data to determine how quickly they need to reach those targets or if the targets need to change.
- Chairman Powell admitted the Fed was wrong in their assessment last year as to the main source of inflation and its strength. They expected the high rate of inflation to come down once the economy fully opened back up and global COVID lockdowns eased. Their assessment as to the source of inflation turned out
to only be part of the story and did not put enough emphasis on the effect of such an extreme quantity of money being pumped directly into the economy through multiple stimulus packages and other liquidity tools. While it’s disappointing the Fed’s leadership team miscalculated so badly initially, I appreciated Chairman Powell’s humble tone and his willingness to admit the mistake. It is refreshing to see humility from someone in high office and I am encouraged that they are responding to be more
aggressive as they see conditions change.
- The Fed is willing to be more aggressive because the data indicates the economy is still strong enough to handle more aggressive moves. There is much speculation among certain journalists and media outlets that we are already in a recession or about to be in one. However, the data coming out of the economy
still indicates the economy (and consumers as a whole) are still financially strong enough for the Fed to move forward. The silver lining of the measures taken to combat the economic impact of the COVID-19 pandemic is they created a lot of momentum in the economy. It will take time to slow it all down.
- Chairman Powell also indicated the Fed is by no means trying to cause a recession. Their goal is to do whatever it takes to tame inflation and create price stability while still maintaining a strong labor market. The labor market itself is so out of balance today that it too has a significant amount
of runway before it gets close to an unemployment level indicative of a recession. Chairman Powell pointed to the data showing there are approximately three job openings for every one person looking for work. This is putting considerable upward pressure on wages as employers compete for talent. While higher wages are a good thing in general, the cost of those higher wages has to come from somewhere. It is typically passed on to consumers in the form of higher prices for goods and services.
In other words, too much upward pressure on wages also serves to push prices higher and make the inflation problem worse. Therefore, some increase in the unemployment rate could actually be part of the solution in the fight against inflation.
- Finally, Chairman Powell was very clear that they are going to continue monitoring the data that comes in and be nimble but forceful in tackling inflation.
The overall picture presented in yesterday’s meeting is that inflation remains stubbornly high and is the number one issue facing the US economy today. There are many contributing factors and many of them are completely outside
the Fed’s control. Russia’s war against Ukraine is just one example. The leadership team at the Fed was too slow in their response initially but seem to have recognized their error and are changing course.
Given the choice between an overconfident Fed that thinks it knows exactly what the problem is and how to fix it regardless of evidence to the contrary or a humble Fed that is thoughtfully trying to be “less wrong tomorrow”…
I’d prefer the humble approach. We are exiting a period of time in which our government used tools and strategies it had never used before, at a scale they never thought possible to fight a problem they had never dealt with. Anyone who is claiming they know exactly what happens next or has some magic bullet the Fed hasn’t thought of is either a fool or has a new book coming out soon they want to sell.
As uncomfortable as it is, we need to focus on the things we can control for now while those who have been tasked with managing our institutions apply their full expertise and resources to navigate through this season safely.
Individuals can do their part by focusing on reducing their debt level, revisiting their budget to accommodate the higher cost of living for the next several years, being thoughtful in how our scarce resources are used and revisiting their financial plan as necessary.
Most importantly, we can be actively looking for opportunities to help those in need as not everyone has the capacity to absorb these higher costs. It might be as simple as buying a few gift cards from your local grocery store
to give out as you see needs in your community. It could also be donating essentials like diapers or canned goods to your local nonprofit or food bank. Small acts of generosity can go a long way toward helping those who are hit especially hard by higher costs. This is just a season and it will change at some point. In the meantime, we need to focus on what we can control and help each other get through it.