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Interest rate hikes slow the economy. So why did the Fed just announce one?

Janet Yellen Addresses Joint Economic Committee On State Of US Economy
Federal Reserve chair Janet Yellen
Photo by Win McNamee/Getty Images

The Federal Reserve has raised short-term interest rates, doing so for only the second time since the 2008 financial crisis. The move reflects the Fed’s growing confidence that the economy is on a sustainable growth footing — and its judgment that inflation is becoming a bigger danger to the US economy than sluggish growth or another recession.

A central bank like the Fed faces a basic trade-off between economic growth and inflation. When the Fed cuts interest rates — or keeps them low — more cash flows into the economy and business tends to boom. That’s good up to a point, but if the Fed provides too much stimulus, it can lead to high inflation. The Fed made that mistake in the 1970s, when inflation reached double-digit levels.

Conversely, when the Fed raises interest rates — as it did today — less cash flows into the economy. That can lead to slower economic growth, with fewer jobs created and slower wage growth.

The Fed decided to raise interest rates today despite the fact that its preferred measure of inflation came in at 1.7 percent over the past year — below its 2 percent target.

Normally, if inflation is too low, the remedy would be to cut rates, not raise them. So why did the Fed decide higher rates were in order? The Fed is concerned that inflationary pressures can build up over time, and that there can be a lag between Fed decisions and the resulting impact on inflation. In other words, it’s worried that if it were to keep interest rates low for the next few months, it might find itself with surging inflation in 2018 — and be forced to raise rates more drastically to deal with the problem. That, in turn, could trigger a recession.

So the Fed is hoping that slowly and gradually raising rates — it did its first post-recession interest rate hike a year ago — will strike a careful balance between the twin dangers of inflation and recession.

The potential downside here is that a premature rate hike could prevent the economy from enjoying a robust economic boom. By some measures, the current economic recovery has been the weakest in decades, and some economists wonder if easier monetary policy could deliver a more robust economic expansion. But so far, that argument doesn’t seem to have changed the minds of Fed decision-makers.

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