By Howard Schneider

WASHINGTON (Reuters). U.S. politicians understand that inflation is a risk to their public careers. But it is up to Federal Reserve officials, who are unelected, to regulate what is essentially a “monetary phenomena.”

The Fed is feeling the heat again, with inflation reaching a record 40-years high and war in Europe likely to drive it higher.

Federal funds rate is the main instrument of the U.S. central banking to manage inflation. It governs short-term loans between financial institutions, and acts as a bedrock for all other loans. Since the outbreak of coronavirus, it has been close to zero. This is why home mortgages have been so affordable.

This is changing. As part of an effort control inflation which the Fed’s preferred measure of is at 6% each year, the Fed voted on Wednesday to increase the federal fund rate by quarter of a point to a range of 0.25 to 0.50%. In an effort to fight inflation, Fed policymakers have laid out plans for what amounts a rate increase at their six remaining meetings in 2018. This is a classic battle that few saw coming.

Rate-increase cycles such as this have the purpose of reducing consumer and business spending. Consumers won’t tap home equity loans if they have higher interest rates, so it is less likely that they will be used to purchase furniture or renovations. Price rises should be resisted by reducing demand. The Fed ultimately wants inflation to hover around 2% per year.

All of the Fed’s attempts to tighten its monetary policy did not work in the same manner. Some led to recessions, which led not only to lower inflation but also economic growth and job losses.

How will this year’s hiking season unfold? Although there aren’t any perfect parallels, recent hiking cycles may offer lessons.

Fed hard and soft landings https://graphics.reuters.com/USA-ECONOMY/HIKES/mopandembva/

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THE 1970S AND EARLY 80S: OIL SHOCKS, STAGFLATION, REESSION

A Fed policy mistake that was one of its biggest and most regrettable set the scene for one of its greatest, most painful successes.

Arthur Burns, Fed Chair, failed to increase interest rates after being under pressure by Richard Nixon in order to reduce unemployment before the 1974 election. Although Burns did raise rates eventually, inflation took hold.

Burns plays catch up https://graphics.reuters.com/USA-FED/HIKES/jnvwebnndvw/

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Current Fed officials won’t discuss similarities between today and 1970s. There are many similarities. But there are commonalities. The 1973 embargo by Arab nations and six-years later the Iranian revolution led to skyrocketing fuel prices in the United States.

Paul Volcker was the Fed Chair who had to end the cycle of inflation that reached 14%. But he pushed so high interest rates that home loans at 18% were almost as costly as credit cards today. The economy was then plunged into two recessions.

Some say it was the only medicine that could save an economy. However, it came at a high price: in 1982 the unemployment rate was over 10%.

Volcker takes control https://graphics.reuters.com/USA-FED/HIKES/mopandgebva/

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GREENSPAN – THE ANCHOR MODERATION, AND CRISIS

In 1987, Alan Greenspan was appointed Fed chief. He is often credited for finishing Volcker’s work. Greenspan’s leadership cemented the public trust that Fed would control inflation, creating a psychological “anchor”, which may help to limit actual price increases.

Greenspan’s hiking cycles weren’t as brutal as Volcker’s and he’s credited for what’s known as a “soft landing”, a period in which policy was tightened but not devastated by recession. The new century began with a brief downturn, which was also due to the crash of technology stocks.

Greenspan’s reputation suffered a significant decline less than 2 years after he resigned from the Fed in 2006. This was shortly before a housing crash in the U.S. triggered the financial crisis. Many cite his willingness to reduce interest rates while allowing banks to operate more freely – an unbiased market view that allows investors to take calculated risks and is believed to have contributed to the crisis.

Although interest rates rose from 2004-2006, the 2007-2009 US recession was more about borrowing costs than it was the spread of mortgage frauds through the financial sector.

The Greenspan years: Anchoring and moderation https://graphics.reuters.com/USA-FED/HIKES/zgvomzgogvd/

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The Greenspan years: Lowflation settles in https://graphics.reuters.com/USA-FED/HIKES/egvbkqdzypq/

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Greenspan’s years: Did they pull the punchbowl late? https://graphics.reuters.com/USA-FED/HIKES/gkvlgaorapb/

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A NEW ERA?

The financial crisis of 2008 and the recession that followed have left U.S. central banks grappling with an unfamiliar world. Inflation seemed to be stable at or below their target of 2%, while global interest rates were declining.

For the first time, rates were cut to almost zero by the Fed during the crisis. This was continued until 2015 The Fed chair Janet Yellen was replaced by Jerome Powell as Fed chairman. However, rates were not raised as much as anticipated. Before the recession was caused by the coronavirus pandemic, there were signs that the economy was in stress. The hiking cycle was cut short.

Yellen and Powell lift off (sort of) https://graphics.reuters.com/USA-FED/HIKES/zgpomzgqgpd/

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Many factors will determine the outcome of this battle, such as whether war in Ukraine ceases or escalates. Already the impact of Russia’s aggression on Ukraine’s neighbor looks less pervasive than that of 1970s. Analysts and investors do not believe that the Fed would need to use Volcker-style aggressiveness to bring down prices.

But that doesn’t make it easy. Actually, the Fed hopes that inflation returns to the same trend as before the pandemic. The economy is now moving towards less globalization, higher prices for supply chains and tighter labor markets. But that’s far from certain.

The post-COVID liftoff https://tmsnrt.rs/3wkV4fM

The COVID inflation surge https://graphics.reuters.com/USA-FED/INFLATION/jnvwewdbwvw/

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