The Fed is no longer taking baby steps to rein in inflation

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At the start of the year, few members of the Federal Reserve’s rate-setting Federal Open Market Committee (FOMC) were calling for an aggressive “front-loading” of interest-rate rises to tame inflation. Today, with America’s consumer-price index running at more than 9%, this has become the consensus. The Fed has adopted the fastest pace of monetary tightening in decades. In the past three months alone it has raised its benchmark federal-funds rate by two percentage points, including a three-quarter-point rate rise on July 27th. Futures markets now expect the rate to rise to 3.4% by the end of 2022, up from 0.8% in December (see chart).

Other central banks are following suit. In June the Bank of Canada surprised markets with a one-percentage-point rate increase. This month the European Central Bank raised its benchmark interest rate by half a percentage point, the most in two decades and more than most observers expected.

The rapid rise in rates marks a departure from the Fed’s traditional approach of making small, incremental adjustments over a long period. Between 1994, when the Fed began publicly announcing changes to its monetary policy, and 2018 it raised the federal-funds rate 40 times. All but five of them were quarter-point increases. Such measured steps, central bankers argue, are less likely to spook financial markets. They also allow policymakers to be more responsive to incoming data, and minimise the chances of policy reversals.

But this time the central bank has fallen behind the curve, says Frederic Mishkin, a former Fed governor now at Columbia University. Had the Fed lifted interest rates sooner, Mr Mishkin says, it could have moved at a more gradual pace. Now that it is playing catch-up, it has to raise them faster and higher—perhaps as high as 5%, reckon some forecasters—to re-establish credibility and keep inflation expectations in check. “They’ve blown it,” says Mr Mishkin. “The good news is they’ve woken up and turned the ship around.” ■