Are the Fed's Interest Rate Hikes Working?
The Federal Reserve has taken an aggressive stance on rising inflation, with the effective federal funds rate rising from 0.08 to 1.68 from January of 2022 to July. This stems from the high current inflation rate, measured by a 8.5% annual increase in the Consumer Price All Items Index (CPI) over the past 12 months. Federal Reserve Chair Jerome Powell has signaled that this push is set to continue, with even more rate hikes to come in the upcoming weeks. The central bank’s strategy has been focused on taming excess demand and reducing wages in a tight labor market where employers are willing to pay more to find more workers.
Source: U.S. Bureau of Labor Statistics and St. Louis Federal Reserve
The impact of rate hikes are mixed across sectors. Inflation continued to increase, particularly as a result of the energy sector through May and June, but has since subsided with no “new” inflation in the month of August. The job market boomed as well, with 372,000 new jobs in June alone. The housing market, however, has slowed down, easing fears of a potential housing bubble and subsequent crash.
While interest rate hikes do help curb demand inflation, a large component of current inflation is a result of the supply side. The New York Federal Reserve created a decomposition model to determine the relative contribution of demand factors and supply factors to overall inflation which found that over the 2019-2021 period, 60% of inflation was explained by demand factors while 40% was due to supply constraints. With major supply-chain issues stemming from the Ukraine conflict, the model’s conclusion helps explain why the Fed’s approach of interest rate hikes is not the panacea for the current high rates of inflation. Supply-side issues require another toolkit of solutions to alleviate the high prices plaguing numerous sectors of the economy.
With more aggressive policy inevitable in the coming weeks, it is imperative that policymakers recognize that even though interest rate hikes will address parts of the issue, there are many other factors that need to be considered to create an effective plan to reduce inflation across the economy.