An Urban's Rural View

The Fed Decides Recession Is The Lesser Of Two Evils

Urban C Lehner
By  Urban C Lehner , Editor Emeritus
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The Federal Reserve Board's increasing aggressiveness in fighting inflation is evident in the accelerating size of its interest rate hikes--a 25 basis point increase in the benchmark federal funds rate in March, a 50 point increase in May and a 75 point increase in June. (Table courtesy of the Federal Reserve)

The Federal Reserve has decided to throw everything it has into fighting inflation, even at the risk of causing a recession. This means higher-than-expected interest rates in the short term. It could also mean less chance of ultra-high rates further down the road.

The Fed's dual mandate from Congress requires it to aim for both maximum employment and minimum inflation. It usually can't succeed at both simultaneously. For the last few years, maximizing employment had been the Fed's priority.

That changed on June 15, when the Fed raised its benchmark interest rates by 0.75 percentage points and indicated the next hike might also be 0.75 points. The latest increase was not only the largest since 1994, but it came after the Fed had guided markets to believe it would be raising rates by only half a point. (…)

The Fed doesn't like to be in the position of misleading the market. That it opted to do so now is further evidence that even though it doesn't admit to a change in emphasis, fighting inflation has become the Fed's priority. At the press conference following the Fed decision, chair Jerome Powell said: "The worst mistake we could make would be to fail" to bring down inflation. "It's not an option. We have to restore price stability." (…)

In rejecting three-quarter-point hikes a few weeks earlier, the Fed had been trying to fulfill both its mandates simultaneously, combating inflation while avoiding a recession. It was hoping that inflation was starting to edge down and that the public was not developing expectations of continued rapid price increases.

The Fed still hopes to avoid a recession. However, Powell admitted to reporters, "It's not going to be easy. There's a much bigger chance now that it'll depend on factors that we don't control," like "fluctuations and spikes in commodity prices."

In the days before the 0.75 point hike, there had been reports that in May, the consumer price inflation rate had risen to 8.6% and consumer expectations for the inflation rate in the year ahead had risen to 6.6%. (…) With both inflation and public expectations worsening rather than improving, there was a strong argument for the Fed to make fighting inflation its priority.

The stock market seems convinced that's what the Fed is doing. After a brief rally the afternoon of the rate hike, stocks fell sharply the next day, June 16. The tech-heavy Nasdaq was down 4.1%.

Having decided to raise rates faster than previously planned, Fed officials now expect the central bank's benchmark rate, which began the year near zero, to reach at least 3% by year end, with half the officials expecting 3.375%. And the Fed will very likely be raising rates further in 2023.

This will mean pain for business borrowers, including farmers and ranchers, but the pain would likely be worse in the long run if the Fed had decided not to attack inflation full-bore now. Because the worse inflation gets, the harder it is to bring down. When it became dug in at double-digit rates in the 1970s, the Fed had to raise interest rates to nearly 20% to rein it in.

Two big risks face the Fed now. One is that it's still not raising rates enough. As Powell said, the Fed doesn't control oil prices, and if they keep soaring it may require sucking a lot more demand out of the economy to make a dent in inflation. That would mean very high interest rates.

The other risk is that the Fed is raising rates too much, bringing on a recession that will put many Americans out of work without any assurance that the latest inflation figures weren't a one-month blip. Of the two risks, this is the one the Fed seems prepared to take at this point.

In the statement explaining its decision, the Fed said it seeks "maximum employment and inflation at the rate of 2% over the long run" and was raising rates by three-quarters of a point "in support of those goals." (…)

The key words in that sentence are "long run." In the short run, the Fed seems to have decided that -- between a recession and inflation -- a recession is the lesser of two evils.

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