The Federal Reserve, which raised its benchmark interest rate last week, essentially plays the role of a party with two conflicting goals: keeping inflation low and employment high.
Conflict arises when one of these key economic forces emerges. Why? Because the Fed’s favorite way to fix a bad-performing sector is to put one of them at risk.
So as the nation’s central bank embarks on a new attempt at this high balance sheet, let’s consider whether its fight to curb inflation will cost you work.
When the party is over
Here’s the problem: inflation is at its peak for 40 years. On May 4, the central bank embarked on a huge swing in this challenge with its most powerful tool – the interest rates it controls.
The target for the base interest rate of Fed funds was raised this week by half a percentage point, the largest increase in 22 years. And Fed chairman Jerome Powell was pretty clear – there will be more promotions, probably this summer.
Remember that the Fed is like a bartender and we are far from the “last call”!
Central bankers know how to start a party. Their services – cheaper financing – can be a great engine for business. Historically low interest rates in this pandemic era have played a big part in the current mess with inflation.
At the same time, the Fed also has the right to use expensive funding to end celebrations when the party gets out of control. As in 2022.
But will this Fed-style edition work? What are the consequences? And how quickly will we see the results?
My reliable spreadsheet uses several key economic criteria to make the Fed’s result, extracting four decades of data from the Fed’s (St. Louis Fed) interest rate, the U.S. Consumer Price Index (Bureau of Labor Statistics), and unemployment in California ), US Gross Domestic Product (Bureau of Economic Analysis) and California house prices (FHFA index).
Mission: What happens in the three years since the Fed’s biggest quarterly rate hike? For those too young or with bad memories, in those crazy days of inflation in the early 1980s, the Fed made a bold move – creating a recession with double-digit interest rates that froze rising prices.
A review of my spreadsheet says that the Fed’s actions usually cool inflation in the end. Economies need time to adjust to business-limiting jumps in financial costs. But these adjustments also explain why these Fed actions are hampering economic growth and leading to rising unemployment.
Since 1980, the Fed’s funds have increased in almost half of all quarters. Let’s take a look at what history tells us about what happened on average, following the first 25% of all Fed movements in four decades …
The first 12 months
During the year after the large increase in rates, inflation cooled by an average of 0.6 percentage points. This is a significant reduction for an economic indicator averaging 3.3% over four decades.
The wide impact was also quick. Business production slowed down. GDP growth has cooled by an average of 0.9 percentage points – a sharp decline for the economy, which has grown at a rate of 2.6% since 1980.
Initially, California’s influence was muted.
Unemployment fell by only a small 0.1 percentage point as the economic momentum did not decline much. This helps explain why the average house price in the state has risen by 8%. Rising interest rates also often create an influx of buyers who think this is the “last chance” to buy.
Painful second year
The Fed’s rate has cooled inflation again, with rising living costs slowing by another half a percentage point in the second 12 months after a sharp rise in interest rates.
Business output shrank again. GDP growth also fell by 0.2 percentage points.
This widespread weakness is behind the rise in unemployment in California by 0.4 points. And, yes, house prices have risen, but only by 2%. More expensive mortgages – and fewer jobs – stung.
The third year also hurts
Yes, the Fed cut inflation again, cooling CPI growth by another 0.6 percentage points.
However, GDP was essentially equal. Unemployment in California jumped another half a percent. And housing prices in the state rose by as much as 1%.
3 years later
The Fed is pretty good at fighting inflation – 36 months after the big jump in interest rates.
CPI growth has declined in 76% of the three-year periods since 1980. Inflation was 1.7 percentage points slower, a significant change for an economic marker that has been moving at a 3.3% annual rate for four decades.
The accompanying damage in this war on inflation was also significant.
Business in the United States slows down in 65% of cases. The average three-year change in GDP has a growth rate of 1.1 percentage points lower. Remember that GDP growth has been 2.6% per year for four decades.
Unemployment in California is only 57% higher in three-year periods after large interest rate hikes. Still, the average result is an increase in unemployment of 0.8 percentage points, an average of 7.2% nationwide since 1980.
And housing prices across the country? There is an 84% chance that they will increase, but the average profit is 4.4% per year, an increase below the overall rate of appreciation of 4.9% per year since 1980. Yes, rising prices are cooling homes.
Why does an unelected board – the Fed – make this critical choice: inflation or jobs?
You do not expect politicians, especially in this hyper-partisan era, to make important decisions or make sensible decisions if legislation can even be passed. Not a good scenario when rising inflation is not a problem that can be left to simmer for too long.
That means looking forward to three years from now. If you’re still at work and fears of inflation have evaporated, you can even cheer up the Fed.
If you lose your job in the face of the battle with inflation, you will think that the Fed stinks.
Have you heard all the Wall Street chatter about higher interest rates hurting the stock market?
Well, the same math shows that three years after big interest rate hikes, there was an 81% chance of stocks rising – and the average profit was 14% a year versus an 11% annual rate of increase since 1980.
I hate to get tired, but less inflation and less workers can boost the end results of many corporations.
Jonathan Lansner is a business columnist for the Southern California News Group. You can contact him at email@example.com