Photo by Paul Weaver on Unsplash

Some forecasters are predicting the Federal Reserve will increase interest rates five, six or even seven times over the course of 2022. A half-point move may be in the cards for the Fed’s March 2022 meeting, with more to come by July. The case for strong action is strong, but the Fed would have to abandon its thinking about the current economy and also abandon its underlying strategy.

Inflation is raging at over seven percent now. On the positive side, labor is becoming a little more available and manufacturers report fewer supply problems than they experienced a few months ago—but still more than usual.

The negative argument for inflation starts with continued stimulative policy through January 2022, as shown by the Fed’s balance sheet. Even worse, time lags from monetary policy to its effects are long, a fundamental conclusion of economics that the Fed seems to have forgotten. The time lag from Fed action to inflation averages about two years. That’s a simplification, as some impact if felt within a quarter or two, gradually rising to a peak effect about two years after the action, then declining over a couple more years. Those time lags mean that 2022’s inflation rate is primarily triggered by 2020 and 2021 monetary stimulus. The stimulus in those years was huge, so near-term inflation is baked in the cake.

The Fed should have taken decisive action last year. Yet only recently have they acknowledged that our inflation was anything but transitory.

Moreover, the Fed’s current strategy statement emphasizes running the economy hot (my words, their concept). They also will not tighten in response to their forecasts, but instead will wait until actual inflation is too high. In practice, the Fed has not responded to actual inflation when they predicted declines in future inflation rates.

Fear of roiling financial markets may well be a factor, as it was during Alan Greenspan’s era at the Fed. To get to seven rate hikes, the Fed would probably want to give more advance notice than they have so far. They could start with their first hike in March and an announcement that more are to come. Thenceforth they have six meetings scheduled this year, though they could raise interest rates between scheduled meetings in extraordinary conditions.

Most changes made by the Fed are a quarter-point move in the Federal Funds rate, but larger increments could be used, and they have on occasion. (The Federal Funds rate is the interest rate on short-term loans between banks, of large dollar amounts of negligible risk. Historical data are available from the FRED database.)

The best-known guideline for monetary policy, the Taylor Rule, would today dictate much higher interest rates than we have, up around six to eight percent. (Taylor summarizes the rule in a recent EconTalk podcast, and the Atlanta Fed has an easy calculator whereby people can adjust the assumptions and see the resulting interest rates.)The best-known guideline for monetary policy, the Taylor Rule, would today dictate much higher interest rates than we have, up around six to eight percent. (Taylor summarizes the rule in a recent EconTalk podcast, and the Atlanta Fed has an easy calculator whereby people can adjust the assumptions and see the resulting interest rates.)

The economy clearly needs the Federal Reserve to take strong action against inflation, but the Fed has dragged its feet to even get started. They seem intent on running the economy hot and they fear a weakening economy. Thus, they are not acting like an agency that will increase interest rates seven times in 2022. But that prediction of Fed delay is less certain than the prediction that inflation will continue to be high throughout 2022 and into 2023. And high and persistent inflation means that the Fed will eventually need to increase interest rates many times more than seven in the years to come.