Fed Funds Rate Must Reach at Least 6% to Curb Inflation

A Fed Funds rate under 4 1/2% is usually considered expansionary.

Since June, the Federal Reserve has raised interest by 75 basis points four times. In recent history, this is an unprecedented rate increase. The purpose, of course, is to reduce total demand in the economy and bring the inflation rate down. So far, it seems to be working. But to bring inflation down to the Fed’s target, the Fed funds rate must be raised to at least 6%.

A rate that high will result in mortgage rates in the 8% range, which should finally cool demand in the housing market. While new home sales have fallen dramatically since the beginning of 2022, sales in the last few months have increased significantly, even with mortgage rates at 7%. That figure is more than twice the rate seen last year.

Although most of the media concentrate on the people who have been pushed out of the housing market due to the higher rates, apparently not enough buyers have left the market. That can be seen by looking at the medium price of a new home which hit a record $493,000 in October. That’s 15% higher than a year ago.

New car sales have fallen, but in October there were 1.11 million units sold, which is 4% higher than October 2021. New car prices reached an average of more than $48,000 which equals the record high price set last August.

Taken together, this means that in the third quarter of 2022 and through October, the Fed’s aggressive interest rate hikes have failed to take enough demand out of the economy to have a large impact on inflation, although it is true that the twelve-month inflation rate has fallen from a high of 9.1% in June to the current 7.7% rate today.

Nearly all the reduction in the inflation rate was due to falling energy prices. In July energy prices fell 5%, then in August they fell by 10% and in September they fell another 5%. Since energy accounts for 30% of the Consumer Price Index, the energy price decline offset price increases in other areas.

The CPI had no increase in July, and it increased only 0.1% in August. In September and again in October the CPI increased by 0.4%. The November CPI number will be released in about two weeks. Energy prices rose in the beginning of November but fell again in the past two weeks.

That will likely keep the CPI in the 0.5% range for November. That means the 12-month rate will increase from the current 7.7%. Just days after that announcement, the Fed will meet. Fed policymakers will raise the Fed Funds rate another 75 basis points to 4.5%. Still, that will not be high enough to bring the inflation rate down to the Federal Reserve’s target of 2%.

That means the Fed will continue to raise rates well into 2023. It appears that the Fed funds rate must be raised to at least 6% before inflation finally recedes. There are a couple of factors working against the Federal Reserve.

The first is the federal government’s fiscal policy. Even though the deficit will decrease from nearly $3 trillion last year, the $1.5 trillion deficit this year will be the third highest ever recorded. Only 2020 and 2021 were higher when massive stimulus spending was used to bring the economy out of the recession caused by the COVID lockdowns.

This year’s huge $1.5 trillion deficit will add much excess demand to an economy already suffering from too much demand. To help reduce inflation, the federal government should turn its spending focus away from solving real or perceived social injustices and toward sound economic policy. That will not happen with the current administration.

The second factor working against Fed policy is the looming wage/price spiral. Organized labor is already demanding large wage increases to “keep up with inflation.” Once these wage increases are granted, the increased labor cost for business will put upward pressure on prices, meaning inflation will increase.

Since demand for interest rate sensitive products like cars and houses remains strong, the Fed must continue to be aggressive with rate hikes. It is true Fed policy will likely result in a recession. But a recession next year is better than having many years of high inflation.