Ed Peters
February 23, 2022

Since 1992, the Fed has been changing rates in anticipation of inflationary pressures building. Alan Greenspan implemented this kind of strategy and announced the Fed Funds target rate. The Fed has continued with this approach to monetary policy, because we’ve been in a steadily declining interest rate and inflationary environment ever since. It was this gradual raising of interest rates that we used to call “cooking the frog,” based upon the old story that if you placed a frog in a pot of cool water and gradually raised the temperature, the frog would be cooked without noticing. Slowly and steadily raising interest rates, 25 basis points at a time, was supposed to reduce economic activity and control inflation without causing a recession. Even though this approach has rarely worked, it’s still been the way the Fed has worked for a generation. Other central banks have adopted this practice, as well.

But prior to 1992, the Fed was generally reactive. It made policy in response to the recent past, rather than trying to anticipate the near future. It didn’t start to move until inflation was well under way. In the extreme case, Paul Volker let interest rates float and controlled money supply instead. This led to highly volatile and very high short-term interest rates. But even when interest rates were targeted, the approach was much more active than the current gradualist approach. Interest rate increases were larger and faster as the Fed tried to catch up.

It appears those days are back. Those who expect the Fed to follow the gradualist “cooking the frog” approach of the last 30 years are likely going to be disappointed. Unless inflation starts falling back on its own, we should see larger and faster interest rate hikes than we’ve seen since 1992. A 2% interest rate target is only valid if we have around 2% inflation. Until we see inflation fall to that level, the interest rate target will be much higher, no matter what the dot plot says. How much higher no one knows, even the Fed.

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