Economic stability: What the Fed can and can’t do to restore it
The Federal Reserve faces a balancing act in the months ahead: tamping down price pressures while also seeking to avoid squeezing the economy into a recession. The institution that Congress tasked with stabilizing prices and keeping the economy on track is aiming to do just that – but with critics saying it bears part of the blame for letting inflation out of the barn over the past year.
“I don’t think the Fed can do too much” to control the supply side of the inflation equation, like the flow of computer chips or oil, says William Yu, an economist at the University of California, Los Angeles. Yet through its influence over money supply and credit conditions, the Fed can affect overall consumer demand, and that’s an equally important piece of the policy puzzle, he says.
Why We Wrote This
The Federal Reserve’s role as stabilizer-in-chief for the United States’ economy is being tested. Global conditions and its own past decisions demand a nimble response going forward.
“The Fed needs to be very careful, very nimble,” he adds.
But some economists say forbearance is warranted, too. “It’s easy to be a Monday morning quarterback,” says Tufts University economist Michael Klein. “In the spring of 2020, we were facing the most precipitous decline in employment that we’ve seen. There was the possibility of a real financial disruption. And they stepped in.”
As the Federal Reserve starts to tighten its money spigot for the economy for the first time since the pandemic began in 2020, today’s boost in interest rates feels different.
This policy about-face comes in circumstances more sensitive than most economic cycles: Inflation is at a 40-year high, a war in Ukraine is rattling global energy and food markets, and the pandemic still weighs on households around the world.
Amid all this, the Fed is expected to act as an economic stabilizer.
Why We Wrote This
The Federal Reserve’s role as stabilizer-in-chief for the United States’ economy is being tested. Global conditions and its own past decisions demand a nimble response going forward.
The central bank is not a wizard, but Congress has granted it vast financial clout – with the mission of pursuing twin goals of price stability and full employment. Historically, this translates into keeping inflation under control and seeking to minimize recessions or financial panics.
The Fed played a big role in facing down a panic in 2020 as the pandemic lockdowns struck. But sometimes the economy’s stabilizer-in-chief can also be a source of turbulence. The current inflation surge has been caused partly by the Fed’s own monetary stimulus, which has boosted consumer demand even as other forces – the pandemic and now war – have crimped supply.
“There are just a lot of really adverse shocks right now,” says Tufts University economist Michael Klein, citing price jumps in 2021 plus surges in the cost of oil and wheat since Russia invaded Ukraine last month. “We’re going to probably see some aggressive moves by the Fed. … There is concern that inflation expectations might become embedded, although the data from financial markets doesn’t seem to suggest that yet.”
A delicate balancing act
Today, U.S. consumers are feeling price pressures at gas pumps and checkout lines. They are signaling their worry in polls on economic confidence. And their expectations for future inflation – which can become a self-fulfilling prophecy – have edged up.
The Fed faces a balancing act in the months ahead: tamping down price pressures while also seeking to avoid squeezing the economy into a recession. And they are under pressure to show a vigilance that hasn’t been so needed in 40 years – since legendary Fed Chairman Paul Volcker tamed inflation with sharp interest rate hikes in the early 1980s.
But even as the Fed has been drawing criticism for being slow to act, some economists say a bit of forbearance is warranted.
“It’s easy to be a Monday morning quarterback,” says Dr. Klein, executive editor of EconoFact, a website where academic economists discuss hot topics including inflation.
“In the spring of 2020, we were facing the most precipitous decline in employment that we’ve seen,” he says. “There was the possibility of a real financial disruption. And they stepped in. And it didn’t make the news because [such a crisis] didn’t happen, but it could have been a really problematic thing.”
Similarly, during and after the global financial crisis of 2008, the Fed’s efforts addressed very real concerns.
Helen Popper, an international economist at Santa Clara University in California, says that even as the Fed sought to restore sound growth over the past decade, it hadn’t grown blind to inflation risks. Prior to the pandemic, policymakers had begun to tighten interest rates. Now, that process is beginning again.
“It’s like steering a big boat. You can’t react to every little thing,” she says.
Macrotrends, U.S. Bureau of Labor Statistics, World Bank
“They were too confident”
Some worry, however, that the Fed has fallen behind the curve, making it harder to simultaneously tamp down inflation and avoid a recession.
A new policy framework in 2020 described public inflation expectations as “well anchored” and said an “appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
Mohamed El-Erian, a finance expert and president of Queens’ College at the University of Cambridge, wrote recently that “that [framework] quickly became outdated and counterproductive.”
On one hand, the Fed had reason to focus on reviving the pandemic economy – which is still falling short of pre-pandemic employment levels.
But on the other, the central bank’s own stimulus was matched by big spending packages from the U.S. Congress. All of that bolstered consumer demand even as supplies of goods were being constrained by the pandemic’s effects on the global supply chain and on the availability of workers.
And now the war in Ukraine and a new COVID-19 lockdown in parts of China will be adding to global strains on the supplies of everything from oil to grains to manufactured goods like phones and cars.
“Right now we need tightening. … The Federal Reserve really kind of played down this inflation problem,” says William Yu, an economist at the University of California, Los Angeles. “They were too confident that they were able to control it” and are playing catch-up.
“I don’t think the Fed can do too much” to control the supply side of the inflation equation, like boosting production of oil or semiconductors, says Dr. Yu.
Yet through its influence over money supply and credit conditions, the Fed can affect overall consumer demand, and that’s an equally important piece of the policy puzzle, he says.
What lies ahead is a delicate test in which one danger is “stagflation” – with policymakers achieving stability in neither prices nor economic growth.
“The Fed needs to be very careful, very nimble,” Dr. Yu says.
An era of global inflation?
After today’s move – which raises the Fed’s short-term lending rate from near zero (induced by the pandemic) to a target of 0.25% to 0.5% – additional interest rate hikes are expected in coming months as part of a steady shift away from monetary stimulus.
Multiple events outside the Fed’s control could help too. An easing of the war in Ukraine, global efforts to boost food and energy production, or unwinding kinks in the global supply chains would all reduce price pressures.
Yet some finance experts say an era of global inflation may persist. British economist Charles Goodhart argues that, after a time of abundant labor supply as the Cold War ended and China’s market opened, the world is now in a period when working-age people will be in relatively shorter supply in many nations.
Russia’s invasion of Ukraine adds its own longer term danger. A new analysis from experts at the International Monetary Fund says that “increased geopolitical tension further raises risks of economic fragmentation, especially for trade and technology.”
This doesn’t mean solutions won’t be found – by central banks and others around the world.
But “there’s just huge complexity going on here,” Dr. Klein, from Tufts, says. “A lot of these events are beyond what the Fed can control, but it does have to react to them.”
