The Line: The Fed Hikes Again

Gregory Heym is Chief Economist at Brown Harris Stevens. His weekly series, The Line, covers new developments to the economy, including trends and forecasts. Read on for the latest report and subscribe here to receive The Line in your inbox.

The Federal Reserve raised the federal funds rate by 0.75% last Wednesday, which now puts it in a target range of 3% to 3.25%. This marks the Fed’s fifth-straight rate hike and the third-straight 0.75% increase.

This was an expected move, especially after the worse-than-expected inflation data recently released. Chairman Powell has said the Fed is committed to bringing inflation down to 2% and will continue raising short-term rates until that happens. Since core inflation—which doesn’t include food or energy prices—is currently running at 6.3%, the Fed still has a lot of work to do.

Also in the Fed’s announcement were changes to its economic projections. The last time they updated these was in June, and not surprisingly, the new projections were all worse than three months ago. They see GDP growth at just 0.2% for this year, compared to June’s forecast of 1.7%. Unemployment and inflation are expected to be slightly higher than their June forecast, although the unemployment rate is expected to remain historically low.

Perhaps the scariest bit of news in the Fed’s announcement was that they expect the federal funds rate to reach a peak of between 4.5% and 4.75% next year, with no rate cuts until at least 2024. With the odds of a recession increasing every day, that’s not what the stock market wanted to hear. After a crazy day of trading last Wednesday, the Dow finished down 522 points.

After last week’s edition of The Line, I received the following question from a reader:

"Could you talk more about why all these rate hikes are not having the impact on inflation as they should? I understand you feel the Fed started these rate hikes too late, but should we be seeing more effect at this point?"

Great question, and thanks for reading. Let’s start with a quote from the Federal Reserve Bank of San Francisco:

"It can take a fairly long time for a monetary policy action to affect the economy and inflation. And the lags can vary a lot, too. For example, the major effects on output can take anywhere from three months to two years. And the effects on inflation tend to involve even longer lags, perhaps one to three years, or more."

I was always taught rate cuts or hikes typically take a minimum of six months before you see any results. The Fed began this round of rate hikes in the middle of March, so we are just now getting to the point where we would expect to see some change. Some may point to the reduction in the annual rate of inflation as a sign that inflation has peaked, and the rate hikes are starting to work. I think it’s a bit too early to say that, since the annual rate of CPI growth is still 8.3%. And, as the reader correctly mentioned, they waited too long to act, which makes their job that much more difficult.

However, there is another reason these rate hikes might take a longer time to work. As I’ve said numerous times in this column, inflation is too much money chasing too few goods. While supply chain issues are improving, there is still way too much money out there.

What do I mean by that? Look at the chart below, which shows the level of M2 since the start of the pandemic. M2 is basically the amount of money people have in cash, savings and checking accounts, and other short-term investments they can access quickly.

Since March 2020, M2 is up 40%, which has never happened before. While it’s come down a bit recently, I don’t see how we’ll have any significant improvement in inflation until we have more of a decline in the money supply.

Remember, I said inflation is caused by too much money out there, not where interest rates are. With the unprecedented impact of the pandemic and the subsequent government response, I’m not sure anyone knows if just raising short-term rates will be enough to bring inflation down to the Fed’s target of 2%. The Fed is confident it can do it; let’s hope they’re right.

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