The Fed Fights Recessions by Dropping Rates—Unless Inflation’s Out of Control

We may or may not be heading towards a recession. The Fed’s usually the government body that’s caped and suited to fight a downturn in the economy by dropping interest rates.

However, we have the curious case of expanding inflation that in the Fed’s eyes is far more important to tame. That means the usual Fed policy of lowering rates to stimulate the economy may be awol this time around. For now, in any case.

The Federal Reserve, the U.S. central bank, was created in 1913 to smooth out boom-and-bust cycles in the economy.

It has developed a variety of methods to soften the pain of recessions, including:

• Adjusting reserve requirements: how much banks have to hold to make sure it can meet the need if we all go demanding our money back immediately

• Buying bonds: by buying bonds, the Fed increases the money supply in the economy

• Targeting interbank lending rates: the Fed can lower the rate banks use to lend to each other, making it cheaper

But the bottom line is that it all boils down to nudging interest rates lower to boost the economy by encouraging spending and lending.

What’s happening now, however, is that the Fed is raising rates because we’re swimming in heated prices for everything from beef to bacon.

The Fed’s got a tricky job. Make rates too high and the ensuing slowdown throws people out of work. Keep rates low too long, and inflation can get out of hand—which is where we are now.

The Federal Reserve is the U.S. central bank. It has immense power to influence economic activity.

It is a non-partisan entity that can’t be ordered around by the executive branch or Congress. On the other hand, the Fed can’t direct the White House or Congress to cut spending or taxes, because it doesn’t set fiscal policy.[1]

A recession is a significant decline in economic activity that is spread across the economy and that lasts more than a few months,” according to The National Bureau of Economic Research, or NBER, traditionally considered the arbiter of economic peaks and troughs.

The problem is that by the time we have the data to figure out whether or not we’re in a recession, it could be long over or still under way. The NBER has taken as many as 21 months and as few as 4 months to declare its conclusions. Most, but not all, of the recessions NBER identifies consist of two or more consecutive quarters of declining real GDP, or the gross domestic product, a measure of the goods and services made in a country. [2]

Luckily, we have outside economists and non-economists happy to give us their opinions.

• The Conference Board, a non-partisan think tank, also cut its forecasts, citing economic weakness.[4]

• Earlier this year, the Fed slashed its projection for 2022 economic growth to 2.8%, down from the 4% forecast three months earlier.[3]

• Tesla Chief Executive Officer Elon Musk has said he has “a super bad feeling” about the economy.

• Wells Fargo Chief Executive Officer Charlie Scharf said there’s “no question” that the U.S. economy is heading toward a downturn.

• Retailers including Walmart, Target, and Kohl’s have warned that rising fuel and freight costs are shrinking profit margins as customers cut back on spending to cope with inflation.[5]

• Former Fed chair Ben Bernanke told the New York Times he expects “a period in the next year or two where growth is low, unemployment is at least up a little bit and inflation is still high.”[6]

Even so, consumer spending and the job market remain strong. It’s quite the conundrum.

The premise behind central bank monetary policy is that people should be able to count on the U.S. dollar’s stability. Whether you’re a business owner or an individual saver, planning is hard enough without having inflation steal your money.

Economists have a number of measures for analyzing inflation, slicing and dicing various economic sectors to try to discern what’s happening. The two main ones are:

• The headline number, Consumer Price Inflation, released monthly by the Bureau of Labor Statistics. May’s CPI showed an annual inflation rate of 8.6%, the fastest rate since 1981.[7]

• The core Personal Consumption Expenditures, said to be favored by the Fed, is released quarterly by the Bureau of Economic Analysis. This one excludes food and energy prices. It was 4.9% in April, down from 5.2% in March. The next report comes out June 30. [8]

Of course, you don’t need an index to tell you that inflation is a problem.

In affluent Greenwich, Conn., a local garden club voted to raise dues for the first time in six years due to increases in the prices of the club’s post office box, MailChimp and Zoom accounts, and meeting room fees. The usual gossip about soaring real estate prices was interspersed with new anecdotes about how it’s twice as expensive as last year to fill a tank with gasoline. [9]

Meanwhile, for the rest of us, customers of Dollar General stores have noticed that nothing seems to be priced at $1 any more. Dollar General's rival, Dollar Tree, said in November it would make $1.25 the base price at all its stores.[10]

Keep to its present plans for raising the federal funds rate, unless some drastic development plunges the economy into a deep downturn.

Cut interest rates or stop raising them. Expectations of more rate increases over the next few months have already begun to slow the economy.

“If the rate increases didn’t happen, I think spending would speed up again,” Scott Sumner, a monetary policy research associate at George Mason University’s Mercatus Center, says.

President Joe Biden and Fed Chair Jerome Powell said in May that controlling inflation is their primary economic goal.[11]

Declare another round of quantitative easing, Fed jargon for buying bonds from banks.

QE began in 2008 to help banks survive the near-collapse of the financial system during the subprime crisis. After a break between 2017 and 2019, the Fed started buying again when COVID-19 hit in March 2020 and kept it up until March of this year. Reviving the program would pour more fuel on the economy.

• 1979: To combat soaring inflation set off by oil price shocks, the central bank—despite an already stagnant economy—drove interest rates above 20%. The rate hikes sent unemployment to a postwar record, but by the summer of 1982 inflation had fallen from a peak of 14.6% into single digits and the Fed started cutting rates. By the end of 1982, inflation was at 4%, setting the stage for decades of low inflation. In his memoir, then-Fed Chair Paul Volcker wrote that he was convinced that the longer inflation accelerated, the greater the risk of a deep recession.[12]

• 1987: The Dow Jones Industrial Average tumbled 22.6% on Oct. 19—still the largest decline ever—threatening to trigger a global crisis. The next day, then-Fed Chair Alan Greenspan pledged that the Fed would “serve as a source of liquidity” to the system. Greenspan’s behind-the-scenes encouragement to banks to keep lending on their usual terms calmed the markets. No recession or banking crisis followed.

• 2008: Bad loans and lax securitization standards in the subprime mortgage market, an unintended consequence of federal efforts to help the disadvantaged, almost brought down the world’s financial system. To keep banks afloat, the Fed under Chair Ben Bernanke bought bonds and slashed interest rates.[13]

• 2018: After a decade of near-zero rates, the Fed finally began to raise them a bit under Chair Jerome Powell. When the COVID-19 pandemic response kneecapped the economy in March 2020, the Fed lowered rates to near zero again.

The COVID-19 pandemic and the government’s response to it created an unprecedented set of economic disruptions.

To help people weather the economic devastation, the government sent out $6 trillion in relief, 50% more than pre-COVID annual federal budgets, increasing the federal debt by 30%.

Meanwhile, people started spending money on goods rather than services. In fact, they bought more than ever before, and more goods were supplied than ever before. Even so, supply couldn’t keep up with demand.

And the shocks just kept coming. This year:

• Energy prices got a dose of rocket fuel after Russia’s invasion of Ukraine disrupted supplies.

• Draconian lockdowns in China further skewed the supply chain, even as certain under-the-radar trends came into the spotlight. Once laser-focused on exports, China had changed its policy a few years ago to favor domestic consumption. It also restricted energy-intensive manufacturing to fix the country’s severe pollution problems. The moves resulted in bizarre shortages in the U.S., where certain brands of cat food became almost impossible to find because China was reserving aluminum cans for the domestic market.[14, 15]

Because inflation is currently higher than interest rates, real rates are negative.That means that if you bought a bond in January 2021, you’re down 90%.

The idea that the federal funds rate should be higher than inflation—known as the Taylor rule—was advanced by Stanford economics professor John B. Taylor in 1993. The formula prescribes a federal fund rate given inflation and how much economic growth is off from what’s desired.[16]

Right now the rule prescribes an interest rate 2 percentage points above the current inflation rate, according to Stanford economist John H. Cochrane, one of Taylor’s colleagues. That would translate to 8% or 9%, depending on the inflation measure used, up from the current 1%. [17]

Raising interest rates by even 5 percentage points, however, would add $1.2 trillion in extra interest costs to the national deficit every year.

It’s fine to borrow when you have a reasonable repayment plan, but maybe a point comes beyond which there is no reasonable plan. “You can’t just print money and count on the economy to produce more and more,” Cochrane says.

While today’s situation has drawn comparisons with 1970s stagflation, economists are hoping the remedy won’t be to raise rates above 20%, as then-Fed Chair Volcker did. Such drastic action would be far more risky today. In 1980, debt was 25% of GDP. It is now 110% of GDP. Adding trillions in extra interest costs to the debt by massively increasing rates could have severe consequences.[18]

• Buy and hold stocks for the long term. Recessions happen, but they usually pass after a couple of years. Stocks are a bet on the U.S. economy. Buying bonds during a recession, on the other hand, are a bet that inflation will be zero.

• Build an emergency cash cushion.

• Don’t put all your chips on one number, or place your faith in one guru. Opinions are all over the place for a reason: Nobody—not the Fed officials, not the smart economists, not the federal government—really knows what will happen next.