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Interest rate hikes follow familiar playbook, may not tame stubborn inflation quickly

Federal Reserve Building Fed
Posted at 11:09 AM, Sep 20, 2022
and last updated 2022-09-20 14:12:59-04

The Federal Reserve is expected to raise interest rates again Wednesday, as part of the continued effort to bring down inflation.

It will be the fifth interest rate hike in about six months.

"We started from what were rock-bottom, record-low interest rates, and now we're seeing this breakneck pace of rate increases," said Greg McBride, chief financial analyst at Bankrate.

The Fed's move could raise rates to levels not seen since 2008.

While it's considered a drastic measure, most experts believe it is necessary to tame historically high inflation.

Prices increased 8.3% in August of this year compared to 2021.

In the 2010s, the average year-over-year price increase was dramatically lower, often hovering around two percent.

"We lived in an era where people thought inflation was over," said Stephan Weiler, a professor of economics at Colorado State University. "Basically, we were seeing inflation rates of 1 or 2 percent, and we believed had conquered inflation."

How to fight inflation

Today's situation, though one of the worst of the last 40 years, remains rosy in comparison to the so-called "Great Inflation" of the late 1970s.

Inflation topped fourteen percent at some points.

Like today, consumers faced sudden spikes in the cost of food and energy, especially meat.

The rapid rise in prices famously led Archie Bunker, the lead character on sitcom "All in the Family," to eat his spaghetti without meat.

"I feel like I'm back in the late 70s talking about this," said Weiler. "But it was the same sort of situation, and we did get out of it."

Federal Reserve leaders of the 1970s and early 1980s said they had to raise interest rates in order to show the public they were serious about taming inflation.

People and businesses had become accustomed to rising prices.

As a result, they planned for large price increases each year, perpetuating the cycle of inflation.

"Inflation feeds in part on itself," Federal Reserve chair Paul Volcker said in 1979. "Part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations."

Volcker's Fed raised interest rates as high as 19%.

The strategy worked in taming inflation, but it came with a price.

High interest rates triggered a pair of recessions in the early 1980s. More than 4 million Americans lost their jobs as a result.

"Today, the Federal Reserve is trying to avoid that recession," Weiler said. "This is what you'd call the soft landing."

The modern inflation battle

It remains unclear if the Federal Reserve will achieve that soft landing.

Many analysts remain skeptical.

"I think a soft landing becomes less and less likely by the day," McBride said. "There hasn't been any signs of hope that inflation is getting under control. And as long as that continues to be the case, the Fed has to continue to push interest rates higher and press on the brakes to get demand down enough to bring inflation under control."

While it's unlikely interest rates will reach the highs seen in the 1970s and 80s, most analysts agree that we will see an increase in the unemployment rate over the next year, as businesses attempt to cut costs and reduce borrowing.

And there is no guarantee that elevated interest rates will be the panacea for inflation.

"The numbers these days are, in some ways, unprecedented," Weiler said. "Could inflation be 5 percent a year from Christmas? I think it's certainly possible."

The path forward

Weiler's analysis lines up with popular sentiment: Most people believe inflation will still be close to 6 percent a year from now, according to a recent survey by the New York Fed.

"I think the Federal Reserve will start to slow down the pace of interest rate hikes probably in early 2023," McBride said. "They want to try to front-load as much of that this year as they can, because it takes six to nine months for the impact of a rate move to really cycle through the economy."

Experts said there are steps people can take now to clean up their finances in anticipation of higher interest rates.

"If you have a credit card balance," McBride said, "grab a low-rate balance transfer offer, transfer that balance to a lower rate card, and then give yourself that runway so that you can get that debt paid off once and for all. You don't want to be lugging that debt balance into a higher-rate environment."

"If you have loans outstanding that are a variable, they are going to go up," Weiler said, "and so that's something that you want to focus on as well."

Most importantly, experts said not to expect prices to return to pre-pandemic levels.

"As inflation comes down, that doesn't necessarily translate into prices coming down," McBride said. "In a lot of instances, it just means prices going up at a slower pace."