Tracking the Fed: Why Did It Take So Long to Stop Inflation?

A perfect storm has been brewing in the U.S. economy. Supply constraints coupled with increased demand built up during the pandemic have led to rapid inflation. The Fed is now taking action by raising interest rates significantly, a move that has many worried about the impending recession soon to follow. While a housing market crash is not anticipated, economists are predicting more inventory and a cooling market due to the interest rate hikes. 

In an episode of BiggerPockets’ On the Market Podcast, we spoke with Nick Timiraos, Chief Economics Correspondent for The Wall Street Journal, to get his thoughts on the Fed’s plans now that the Fed has increased its interest rate by 0.75%, the most aggressive increase since the 1990s.

The Difficult Task of the Federal Reserve

Timiraos says to think of the Federal Reserve System as “a bank for banks,” because the Fed controls short-term interest rates. The Fed doesn’t directly set mortgage rates but determines the interest rate banks pay to borrow from their reserves overnight. 

The Fed is charged with the difficult task of monitoring and maintaining the economy’s health in a couple of ways. “They have two goals assigned to them by Congress: to maintain stable prices and to have maximum employment,” explains Timiraos. “And you could think of that as the most employment possible without having inflation. And those are their two goals. And then, in addition to all of that, they’re charged with regulating the banking sector.”

When the Fed reduced interest rates at the onset of the pandemic, they were trying to stimulate the economy. As they increase interest rates like now, they’re doing it to slow down inflation, which inevitably slows down the economy. 

What is Causing Inflation?

The problem started with the $5 trillion stimulus package for pandemic relief. The federal government’s response resulted in much higher inflation than we currently see in other countries. In the short term, it may have appeared that they achieved the intended result of providing more financial stability to families. But national debt must be repaid. The government must, at some point, tax more than it spends. Federal Reserve economists estimate that pandemic spending contributed about three percentage points to the inflation we are experiencing now. 

In the long run, any government attempt to stimulate the economy by creating money without also increasing production leads to harmful inflation. But the impact of the pandemic was so swift and far-reaching that it would have led to deflation if the government hadn’t stepped in. And meanwhile, food and housing insecurity was rising. About one in five children may have experienced food insecurity during 2020. So despite knowing that distributing more money into the economy would debase the currency, the federal government was most concerned with the greater implications of starving children and broad housing insecurity.

Then, when lockdowns were lifted, there was a pent-up demand for goods and services, along with extra money for consumers to spend. “You have a lot of demand. You have more people working, making more money, spending money on things,” says Tirimaos. 

But, at the same time, global supply chain issues have prevented producers from keeping up with demand. That’s pushed the inflation rate to 8.6%, according to May’s CPI report, and now the Fed will do whatever it can to keep that rate from rising. 

“The Fed can’t do a lot in the near term about the supply side of the economy,” explains Tirimaos. “They can’t create more oil, they can’t create more houses, their tools just don’t do that. So when they talk about bringing supply and demand into balance, they [need] to get lucky, they need to get supply chains moving again.” 

Or, they need to do something to curb demand so that a balance between supply and demand can be achieved. 

That’s the goal of raising the benchmark interest rate. When the Fed’s rate rises, its effect spreads into the mortgage market, the auto market, and increases the cost of borrowing business loans. Overall, people become less likely to borrow and purchase homes or vehicles. “And also businesses hire fewer workers. And so people have less overall income. And so they don’t spend as much money,” says Timiraos. 

Why the Fed is Taking Action Now

If inflation has been a problem since last year, why is the Fed suddenly getting aggressive with interest rate hikes? 

During the pandemic, specific supply-constrained industries, such as new and used cars, saw the highest price increases. “And so for a while, of course, the Fed infamously said, and a lot of private sector economists agreed that this was transitory,” says Timiraos. “The idea behind that was that inflation was really driven by the pandemic. And assuming the pandemic was over with quickly, inflation would be too.” 

But more fuel has been added to the fire since then. The war in Ukraine caused inflation in the global energy market and supply chains never recovered as well as they needed to. The problem no longer seems transient, which has the Fed concerned. 

“They’re worried that one year of high inflation is okay, but if we have a second year of that, people are going to begin to build expectations of higher prices into their wage setting and price setting behaviors. And that psychology is something the Fed really strongly wants to avoid.”

The Fed’s goal now is to achieve a neutral interest rate, says Tirimaos. “A neutral interest rate is the level the Fed thinks isn’t providing any stimulus to the economy. If you think of the economy as a car and the Fed is the driver, they’re taking their foot off the gas. They’re not pushing on the brake, but they’re trying to find that place where they’re no longer pushing on the gas, not necessarily stepping on the brake.”

The Fed is “not trying to induce a recession,” says Federal Reserve Chair Jerome Powell. But it will do whatever it takes to slow down the overheating economy, which could very well implicate a recession.

What About Asset Prices?

Real estate appreciation isn’t factored into the Fed’s assessment of inflation, but the Fed is charged with overseeing the financial system’s stability. So in that way, Tirimaos says, they’re concerned about rapidly rising asset prices. “Now, there’s been a big debate over the last 10 years which is: should the Fed raise interest rates even if inflation’s contained and even if they’re meeting their mandate unemployment, but to prick a bubble? Because an asset bubble could jeopardize their ability to achieve both of their other goals. And the argument has generally been, no, we shouldn’t use interest rates. We shouldn’t raise interest rates to prick asset bubbles.”

But in 2022, inflation is so high that the Fed needs to raise interest rates regardless. Curbing the asset price boom simultaneously is a “happy coincidence” rather than a direct goal. 

Still, a cooling housing market aligns with the Fed’s goals. “They want [economic] activity to cool, they want to remove some of that excess demand that you have right now. And so if you’re in situations where homes that used to be getting 10 or 30 offers are now getting three or four, for the Fed, that’s probably a healthy development.”

What This Means for Consumers and Investors

The Fed is attempting a “soft landing” that won’t result in a recession, but the chances of this are slim, with history as a guide. Dave Meyer, VP of Analytics at BiggerPockets, writes, “As the Fed raises rates, many parts of the economy will be negatively impacted.” These include a falling stock market and a loosening labor market. “With all these factors converging, I believe a recession will likely come in the next couple of months.” 

The best thing Americans can do in preparation for a recession is to save aggressively and invest for the long term. Experts recommend adjusting your budget to bolster your emergency fund in anticipation of layoffs. Once your emergency fund is adequately funded, invest in the stock market while prices are low—or invest in real estate, which is typically more stable. 

Investors relying on mortgages to make deals will have their margins constrained by rising mortgage rates, so they’ll need to factor that into investment decisions. Make sure the deal is profitable with the current rate, but remember that refinancing may help increase your profit margins later on if we see interest rates fall again.