How High Will the Federal Reserve Raise Interest Rates?

First, consider the optimists, who think that inflation will come down without the Fed having to inflict too much damage on the economy. Many still hold on to some version of the idea that inflation is driven primarily by supply chain disruptions, which must resolve themselves at some point, and they have spotted positive signs of a trend reversal in bellwether prices such as those for used cars. They think inflation is “transitory”; they just don’t use that word anymore.

The optimists have come around to the idea that the Fed must do something to bring inflation back down to acceptable levels, but not much. They also think that 3% inflation would be just fine and that the Fed will come around to a similar view. They are aware of the upward pressures on wages but think it’s hyperbolic to talk about a wage-price spiral, in which rising salaries and the cost of consumer goods feed upon each other in a toxic feedback loop that elevates inflation for an extended period. Optimists will recognize that there are too many job openings in this hot labor market — nearly two jobs for each unemployed worker — but are reasonably confident that the Fed can reduce the number of openings without necessarily driving up unemployment.

Optimists will generally note, correctly, that neither the stock nor bond market are adequately priced for this scenario. If the optimists are right, consumers will keep spending and buoying the broader economy, supported by all the money they saved during the pandemic. For the optimists, short-term bond yields are already too high and stocks are too low.

The pessimists look at similar data but settle on a much gloomier outlook. They may well think that supply chains partially caused this inflation, but they rightly observe that inflation is now broad-based, as shown by measures of underlying inflation produced by the Atlanta, Cleveland and Dallas Feds.

They will tell you that labor costs tracked by the employment cost index are surging; that the public’s inflation expectations risk becoming unmoored; and that the Fed is so far behind the curve that it must now engineer a recession to get inflation back to an acceptable level.

They will note that markets are far too sanguine for this scenario. Pessimists know their history, and they will tell you all about what happened when former Fed Chair Arthur Burns and his colleagues failed to crush inflation in 1975, leaving it to fester for years. Here was a reflective Burns in November 1976 before the Senate Committee on Banking, Housing, and Urban Affairs:

In 1975, our Nation finally succeeded in reducing the rate of inflation. … Most of this notable progress occurred in the first half of 1975. Since then, there has been little further improvement in the underlying rate of inflation. … [I]nflation continues to erode the purchasing power of the wages and savings of our people at a disconcerting rate.

Asked Wednesday whether he had the courage to cause a recession to tame inflation, Powell offered effusive praise of former Chair Paul Volcker, who did just that. “He had the courage to do what he thought was the right thing,” Powell said. “We see restoring price stability as absolutely essential for the country in coming years. Without price stability, the economy doesn’t work for anybody really.”

We’re not reliving the 1970s, and policy makers have made giant strides in the past four decades in earning the public’s trust and anchoring inflation expectations. Overall, I tend to fall somewhere between the optimists and the pessimists, and so does the market, where the S&P 500 Index is down about 10% year to date but is clearly not priced for a recession. That’s why there has been so much push and pull.

In the weeks ahead, policy makers will share their versions of the story. They may not settle on the right one — we know now that they had the narrative woefully wrong last year when Chair Jerome Powell broadcast the idea that inflation was “transitory” — but the committee’s answers to these questions will dictate the course of the economy. It’s hard to know what this Fed should do, so all anyone can do is bank on the members’ commitment to transparency and try to figure out what they will do. Whether the glass is half full or half empty, expect the water to be choppy.