What is the Fed’s logic behind raising interest rates?

Neel Kashkari, president of the Minneapolis Federal Reserve, reiterated the Fed's tightening policy on Tuesday.

He said at an online event hosted by The Wall Street Journal that the Fed needs to tighten monetary policy until it is sure that potential inflation is falling before determining the next policy direction.

This once again clearly expresses the Fed’s determination to raise interest rates. The U.S. stock market has officially entered a bear market, and the close relationship between the crypto market and the stock market also makes the Fed’s macroeconomic policy more far-reaching.

The Federal Reserve raised its benchmark interest rate by another 75 basis points last Wednesday to a range of 3%-3.25%. Central bank officials expect to raise rates to 4.4% by the end of 2022. With only two policy meetings left this year, the central bank is likely to raise rates by another 75 basis points before the end of the year.

What the Fed wants to avoid now is the mistakes of the 1970s. The hyperinflation in the 1970s was also because the policymakers saw the economy weakening and inflation began to decline. Then the Fed's misjudgment of the economy caused them to stop tightening policies too early and start cutting interest rates, which resulted in inflation erupting again and becoming uncontrollable. It was not until Paul Volker took the initiative to raise interest rates to 21.5% in 1981 that inflation was firmly controlled. But the price was that the United States fell into a serious economic recession.

In June, former U.S. Treasury Secretary and current Harvard University professor Summers reminded the Federal Reserve not to repeat the mistakes of the past in a media interview program.

“If we’re going to have a period of pain, it’s going to be very important to make sure that we do slay the dragon of inflation,” Summers said. “There are a lot of examples of failures, the 1970s being a classic example of policymakers doing things like stopping antibiotics when they felt well, even though the 10-day course wasn’t over.”

In fact, since the beginning of tightening, Federal Reserve Chairman Powell has clearly expressed to the market his determination to control inflation. For the United States, even if there are concerns about economic recession, inflation is obviously a bigger enemy. The Federal Reserve must do this for its own reputation and the future smooth development of the U.S. economy.

The Fed raised interest rates too slowly due to misjudgment. The quarterly forecast for 2021 shows that at the beginning of the year, the Fed expected personal consumption expenditure inflation (PCE Inflation) in the fourth quarter to be 1.8%, but it was actually 5.5%. Such a serious forecast error also made Powell insist that inflation was only temporary in the face of rising prices for most of 2021, missing the best time to raise interest rates. Now, in order to avoid high inflation like in the 1970s, the only way is to raise interest rates drastically.

It can be said that the Fed's interest rate hike is not only to control inflation, but also to defend the reputation of the Fed and even Powell personally. Since the 1970s, the Fed has had two responsibilities: one is to control inflation and keep it at around 2%, and the other is to protect employment. As for the ups and downs of the capital market, it is not within the Fed's responsibility. Paul Volker was worshipped and widely praised for controlling inflation, even though the US economy fell into a deep recession. He was deeply involved in the formulation of US financial policies until Obama came to power. The Vokler Rule after the financial crisis was his work. I visited Volker in 2018. He was old at the time, but his ideas were still very fresh.

(Photo of the author and Paul Volker)

The Fed made a big mistake last year by raising interest rates too late. Now Powell cannot help but consider the reputation of the Fed and himself. If inflation cannot be controlled, the disaster of the US economy in the future can be blamed on it. It is an understandable choice to let the economy fall into recession in order to control inflation. At present, the academic community has criticized Powell's professional level. Powell has a bachelor's degree in political science from Princeton University and a doctorate in law from Georgetown University, not a doctorate in economics. Many people believe that if former Fed Chairman Ben Bernanke was in office, the Fed would not make such a mistake.

Bernanke saved the day when the financial crisis broke out in 2008. As a professor of economics at Princeton University, he has devoted his life to studying the Fed's mishandling of the Great Depression. In 2002, when celebrating Milton Friedman's 90th birthday, he said, "You are right about the Great Depression. We (the Federal Reserve System) did make a mistake. We are really sorry." He also promised not to make similar mistakes again. Sure enough, when the financial crisis broke out, he put all his life's learning into solving the crisis. Although the rescue of the market during the financial crisis brought moral hazard, objectively speaking, it was precisely because of Bernanke's professional level that the 2008 financial crisis did not cause a disaster like the Great Depression.

The position of the chairman of the Federal Reserve is extremely important, and the political legacy and reputation of the person in this position will be evaluated very strictly. Even a financial czar like Greenspan, who once reigned supreme, suffered from a reputational damage due to the subprime mortgage crisis caused by his long-term low interest rate policy during his tenure. As a world-renowned figure, his portrait was once very popular, but it has fallen out of favor since the 2008 financial crisis.

Now, facing unprecedented inflation, the Fed led by Powell will resolutely continue to raise interest rates, both publicly and privately. According to the median forecast released by the Fed last Wednesday, interest rates will be raised to 4.6% in 2023 before it is possible to stop fighting soaring inflation.