In January 2022 the Federal Reserve (a.k.a. “the Fed”) faced a challenge: Inflation was 7.5% and the Fed needed to discourage spending to reduce inflation. The Fed has an effective tool for discouraging spending — higher interest rates — but the problem is that the side effects of this medicine can be worse than the disease. Higher interest rates reduce consumer spending, which not only curbs inflation, but also reduces total national income and increases unemployment.
The Fed hoped that they could accomplish a soft landing (that is, fix inflation without causing a recession), but the prospect didn’t look good. Historically soft landings are rare. Typically, when the Fed increases interest rates to stop inflation the result was a painful recession. For example, in May 1979 inflation was 11% and the Fed increased interest rates 9 percentage points over the next year, resulting in the 1980 recession. GDP fell 8% in the second quarter of 1980, and in July unemployment was 7.9%. The Fed dropped interest rates again in the spring of 1980, but this was too soon because it had not yet beaten inflation. With inflation still over 10%, the Fed had to increase interest rate rates again, this time by 12 percentage points, over the fall of 1980. This was strong medicine and unemployment soared, reaching 11.4% in January 1983. But the medicine worked, and inflation fell.
Over the next 37 years inflation generally remained below 5%, surpassing that mark just a little bit in 1990 and 2008. Until Covid.
The recession of 2020 was unusual. In a normal recession, workers are laid off because the firms can’t sell their products. In 2020, though, people were asked to stay home to limit the spread of Covid. People who couldn’t work remotely then had no jobs and no income, but still needed to eat. To solve this problem the government provided checks to every taxpayer. This stimulus money did what it was supposed to do: it allowed people to continue to eat and pay their bills even when they couldn’t work. Unfortunately, the side effect of supporting demand when supply falls is higher prices.
By the summer of 2021 it was clear that inflation was rising. The Fed hoped that this inflation would be transitory, and no one knew for sure what would happen because this was the first pandemic-related recession we experienced. By January 2022 it was clear that they couldn’t wait any longer to administer the medicine. The Fed began raising interest rates, and by July 2023 rates had risen 5.25 percentage points — not as much as during the early 1980s, but still quite rapid. Inflation continued to rise for a while, reaching 9.1% in June 2022, but then fell rapidly over the next year. The medicine had its intended effect: inflation is now 3.4%. That’s four-fifths of the way to the target of 2% inflation.
What about the side effects? This rise in interest rates has not caused a recession. We not only avoided a rise in unemployment; the unemployment rate was 4% in January 2022, and now it is 4%. That’s lower that the unemployment rate was at any time between 2001 and 2017 (or 1971-1999). In Montgomery County, the unemployment rate is even lower, at 2.8%. Consumer sentiment fell to a historic low in June 2022 but has been rising since then. GDP continues to rise.
No one knows the future, but a year and a half after interest rates started to rise, we have seen the beneficial effects of the Fed’s medicine (lower inflation) without any of the harmful side-effects. If this continues, we will have achieved the elusive soft landing.
Source notes: Interest rates, measured by the Fed Fund Rate, and consumer sentiment are from Federal Reserve Economic Data (FRED). Inflation and seasonally adjusted unemployment rates are from the Bureau of Labor Statistics. GDP is from the Bureau of Economic Analysis.
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