Can the Fed Fight Inflation?

February’s Consumer Price Index (CPI) report was not good news for the Federal Reserve (Fed). The report showed that year-over-year inflation stood at 6.4 percent in January. Today’s report revealed inflation was up 6 percent on an annual basis and prices increased by 0.4 percent since last month. The stated goal of the Fed and the Biden administration is to reduce inflation to 2 percent. Eight consecutive rate increases indicate a commitment, albeit halfhearted, towards this goal. Optimistic commentators have suggested that the Federal Open Market Committee (FOMC) may be finished with rate increases. Unfortunately, after a history of recent monetary and fiscal policy is examined, the fight against inflation appears far from over.

On January 1, 1986, the federal funds rate was 13.46 percent. By the end of the year, this rate was higher than 16 percent. Why does this matter? It matters because 1986 was the first year in two decades, since the early 1960s, that inflation in the United States was 2 percent.

Inflation remained very low, less than 2 percent, from 1960-1966. The CPI jumped to 3 percent in 1967 as spending on Vietnam and the Great Society, guns and butter, caught up with the American consumer. By 1970, inflation was 5.5 percent while interest rates were 9 percent. However, even 9 percent interest rates–double the current rate–were not sufficient to tame inflation. The genie was out of the bottle.

Inflation reached frightening double digits by the mid 1970s and the 1979-1981 timeframe. It was during this second stint of double-digit inflation that Paul Volker replaced George Miller, as chairman of the Federal Reserve. (George Miller previously succeeded Arthur Burns whose tenure was disastrous.) Volker was given the political freedom to aggressively fight inflation that, by 1980, was 13.5 percent. He accomplished this only by increasing the federal funds rate to more than 22 percent.

Twenty-two percent is more than five times the Fed’s current rate of 4.5-4.75 percent. Even 20 percent interest rates did not immediately cool inflation. As mentioned earlier, it was not until 1986 that the annual CPI was less than 2 percent. This raises an obvious question. How does the Fed expect to fight 40-year high inflation with only 4.5 percent interest rates? If double-digit rates were required to slow inflation during the 1980s, how many more rate increases can we expect from the Fed?

There is one distinct difference about inflation in the 1970s and 1980s versus our own inflation in the 2020s. The national debt was significantly smaller during the 1980s–the decade in which our government surpassed $1 trillion in debt. Therefore, the cost of servicing the debt in the 1980s was much more manageable even with high interest rates. Despite today’s relatively low rates, the annual cost of financing the $31.4 trillion national debt is $500 billion. If rates were increased to their 1980s levels, interest on the debt alone would cost trillions of dollars annually.

Our current economic woes can trace their origins to the Great Recession. In the years leading up to the crash, the Federal Reserve held interest rates low while the federal government subsidized risky loans and encouraged banks to do the same. Fannie Mae and Freddie Mac, both government sponsored enterprises, lowered the standard for the type of mortgage-backed securities (MBS) they would purchase. By 2007, these two entities had acquired more than $2 trillion in loans. In short, the Federal Reserve began increasing rates in 2005 and by 2007, with rates just over 5 percent, the bubble popped.

In response, the Fed cut rates to less than 0.5 percent and undertook a policy known as “quantitative easing” or QE for short. These low rates enabled the Fed and the federal government to pump trillions of dollars into the economy to “stimulate” growth. Rates would remain practically zero (always less than 0.5 percent) from 2008-2016. A decade of these actions resulted in a doubling of the money supply (M2) and a doubling of the national debt. By the end of 2019, the total money supply in the U.S. was greater than $15 trillion–twice the 2007 M2 of $7.5 trillion.

The Fed started to increase rates in late 2016 and early 2017. Jerome Powell, who became chairman of the Federal Reserve in 2018, suggested that the time was right to start raising rates. Powell immediately faced immense political pressure and quickly backed off. Powell succeeded in increasing rates some, but not enough. Rates were never higher than 2.5 percent during Donald Trump’s tenure. However, by the end of 2019 even these modest increases started to cause panic on Wall Street. Coincidentally, COVID-19 arrived in early 2020 and provided an excuse to drop rates to near zero again.

By March 2020, rates plummeted back to near zero percent (0.25 percent). For the next two years, rates were as low as 0.04 percent and never as high as 0.10 percent until the Fed started fighting inflation in March 2022. The government was able to spend more than $13 trillion and add another $7 trillion to the national debt during this time. These were the same monetary and fiscal policies that doubled the national debt under Obama increased the debt by one-third under Trump. Low interest rates make deficit spending more affordable.

In 2007, the Fed’s balance sheet was less than $900 billion. After a decade of QE, its balance sheet was greater than $4.5 trillion–representing trillions in treasury bonds and MBSs purchased. However, the Fed began to tighten in 2019. An increase in interest rates and a selloff in assets reduced the balance sheet to $3.8 trillion. By 2022, after two years of COVID QE, the Fed’s balance sheet had doubled to $9 trillion.

In March 2020, the M2 supply was about $15.4 trillion. By April 2022, the total money supply was more than $22.05 trillion. More than 30 percent of the dollars in circulation were created in just the last three years. According to the government’s own cooked CPI numbers, inflation would hit a 40-year high of 9.1 percent in June 2022. 

One year ago this month, the Fed, began fighting inflation by raising rates and reducing its balance sheet by selling assets. With these measures, known as quantitative tightening, the Fed hopes to restore inflation to 2 percent. As history shows, 2 percent inflation has largely been the exception and not the norm.

Since 1970, inflation has only been 2 percent or less eleven times: 1986, 1998, 2002, 2009-10, 2013-16, and 2019-20. Over the last 52 years, inflation has only been between 2 and 3 percent thirteen times since 1970: 1993-97, 1999, 2001, 2003-4, 2007, 2012, and 2017-18. Most of the years with low inflation have come since the government changed its methods of calculation.

The Fed follows mainstream economic thinking regarding inflation and the unemployment rate. Preached in academia and believed by those in politics, the debunked “Philips Curve” attempted to prove that an economy can either have low inflation or low unemployment, not both. Stagflation in the 1970s should have ended the belief but Keynesianism is as widespread as ever throughout our government and universities. Mainstream thinking runs thus: inflation is high because the economy is overheated. Therefore, the Fed must increase interest rates resulting in unemployment. An increase in unemployment will decrease the demand for goods and services causing prices to decline.

There are several flaws with this reasoning. First, the purpose of the current rate hikes is not to increase unemployment. The purpose is to increase the cost of borrowing and thereby reduce government spending. Second, the confusion persists that inflation is price increases. Prices themselves are not inflation. In a free market, prices serve extremely valuable functions. They signal to producers what products consumers are demanding. Producers then allocate more resources towards the production of these goods and services.

Lastly, one question not asked is this: Why is 2 percent inflation desirable in the first place? Not only do prices rise every year, but your dollars lose half of their purchasing power every 35 years at this rate. Who would advocate for permanent higher prices? Standard of living improves when your purchasing power increases–when your dollars can buy more not less.

Wall Street, the media, our economic establishment, and politicians have convinced Americans that annual inflation is a good thing. Two percent does not sound like big deal and, if inflation stays low, most people ignore it. It does, however, provide Congress with the cover to continue deficit spending and rob the American people through the hidden tax that inflation is.

Lastly, as I see it, there are four scenarios going forward. One of which, or maybe a combination, will likely play out.

(1)  The Fed will continue to increase interest rates which will result in a recession and higher unemployment.

(2)  The Fed surrenders to Wall Street pressure, media pressure, and more importantly political pressure. The Fed stops raising interest rates and resumes quantitative easing–only creating a bigger bubble and postponing the day of reckoning.

(3)  The Fed revises its inflation target from 2 percent to 4 or 5 percent and justifies the measure with a statement such as “the U.S. economy is now strong enough to handle monetary increases in increments of 5 percent annually.”

(4)  The Biden administration will simply declare that inflation is over, and a compliant mainstream media will attempt to sell the new narrative.