The Federal Reserve can’t do much about inflation caused by energy markets or supply chain issues. It can increase interest rates to temper consumer and business demand which would lower inflationary pressures, through its Open Market Operations. The goal of the Federal Reserve is to act autonomously to balance economic growth with an acceptable level of inflation through targeting the fed funds rate. If the Federal Reserve lowers the fed funds rate, then borrowing costs typically decrease for consumers and businesses resulting in increased spending and economic growth. Too much economic growth can lead to inflation, so the Federal Reserve typically increases the fed funds rate to lower economic growth through decreased consumer and business spending. The novelty of the COVID driven economy was the record-breaking volatility of the economy. The economic decline, in terms of both magnitude and quickness, was greater and quicker than any economic decline since the Great Depression. The economic recovery was greater and quicker than any economic recovery since the Great Depression. The speed of the economic recovery contributed to inflation, as consumer demand recovered quicker than supply chains and global energy supplies. After a robust economic rebound in 2021, the Federal Reserve announced that multiple interest rate increases were likely in both 2022 and 2023 to reduce economic growth, consumer and business demand, and consequently inflationary pressures. The dramatic economic decline caused by COVID prompted the Federal Reserve to reduce the fed funds rate to a historically low range of 0.00% - 0.25%. Interest rates were this low only one other time in the last 50 years, during the financial crisis. In March, the first of several expected rate increases occurred, with the fed funds rate increased to a target range of 0.25% - 0.50%. The Federal Reserve announced in March that the targeted level for the fed funds rate in 2023 was expected to be approaching 3.0%, as interest rates would be gradually raised to counter inflation. Current inflation has been significantly influenced by the double whammy of rising energy prices, fueled by Putin’s war on Ukraine, and lingering COVID driven supply chain problems. While the Federal Reserve can temper demand through increasing interest rates, the impact on future inflation is limited. The effect of Putin’s war on global energy prices and any resurgence of COVID are the biggest threats to drive future short-term inflation, which are not factors that the Federal Reserve can influence. Prolonged significant inflation can reduce purchasing power and consequently real consumer spending, which in turn would negatively affect economic growth and risk stagflation or recession. Due to the great uncertainty of Putin’s war and any future impact of COVID on supply chains, current economic forecasts may be subject to greater uncertainty than ever before.
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Center for Business and Economic Insight
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