The Federal Reserve raised interest rates Wednesday, in an effort to reduce price inflation by throwing cold water on a hot economy.
In the past year, prices have risen at the fastest rate in decades, thanks to pandemic-related supply chain problems colliding with strong consumer demand. Inflation has overshadowed low unemployment and strong job growth among policymakers and consumers alike.
Higher interest rates make credit more expensive for households and businesses, prompting them to borrow less and spend less. If the Fed raises rates aggressively, it could reduce economic activity so much that the economy slides into a recession.
Federal Reserve chair pro tempore Jerome Powell argued Wednesday that interest rate hikes won’t hurt the economy too much.
“The American economy is very strong and well-positioned to handle tighter monetary policy,” Powell said.
The Fed has kept interest rates near zero for years to stimulate job growth, but on Wednesday, with the national unemployment rate at the historically low level of 3.8%, the Fed increased interest rates by a quarter of a percentage point. It’s a small increase, but Powell has signaled the Fed will continue raising rates by quarter-point amounts until inflation slows.
Powell said he expects inflation to slow “in the second half of the year” and “come down more sharply next year.” The consumer price index increased 7.9% in February compared to the prior year.
With uncertainty over the coronavirus pandemic, surging inflation and now the war in Ukraine, economists say it will be tricky for the Fed to achieve a “soft landing” of lower inflation without a surge in unemployment.
“We have a higher risk of slipping into recession than normal, and we have a higher risk of overheating than normal, and when you have more risk at both tails, it’s pretty hard to be sure that you’re getting exactly the right spot in the middle,” Erica Groshen, a senior economics adviser at the Cornell University School of Industrial and Labor Relations, said in an interview.
“It’s a much more complicated and fraught situation than what it was already going to be two months ago,” Groshen said.
During a press conference Wednesday, Powell projected confidence that higher interest rates won’t hurt the economy, citing low unemployment and employers complaining that they can’t find workers.
“The labor market has continued to strengthen and is extremely tight,” he said.
Still, there are clues that the labor market is not as strong as it could be. The percentage of U.S. adults employed or looking for work remains below its pre-pandemic level, and the unemployment rate for Black workers is still twice the rate for white workers.
The job of the Federal Reserve is to maintain stable prices and maximum employment, but tackling high inflation could mean putting full employment on the back burner. Powell suggested as much on Wednesday.
“The plan is to restore price stability while also sustaining a strong labor market,” he said. “That is our intention and we believe we can do that, but we have to restore price stability.”
At a hearing last week, Sen. Richard Shelby (R-Ala.) recalled the way former Fed chair Paul Volcker tamed inflation in the early 1980s, when tight monetary policy quelled rising prices but pushed the national unemployment rate above 10%.
“He brought the leadership to the Fed and to the country that we had to squeeze inflation out at ― at all costs, just ― and a lot of it was draconian,” Shelby said. “You have to do it. Is the leadership at the Fed under you and the Fed prepared to do what it takes to get inflation under control and protect price stability?”
Powell said he admired Volcker and would do whatever it takes to rein inflation in.
“I hope history will record that the answer to your question is yes,” Powell said.