Economy Matters

A third of US adults responding to a national survey think the Federal Reserve should cut interest rates to fight inflation, illuminating a disconnect from the proven practices of the nation's central bank in its fight against inflation.

After inflation jumped in the aftermath of the COVID-19 pandemic, the Federal Open Market Committee (FOMC) incrementally raised the fed funds rate to 5.25-5.5 percent. By raising short-term rates, the Fed wants to increase borrowing rates to slow down overall demand in the economy. This puts downward pressure on prices.

Perhaps the confusion lies in most working-age people having little to no experience with high inflation rates, reasons Brent Meyer, an assistant vice president and economist at the Federal Reserve Bank of Atlanta. Inflation as measured by the Consumer Price Index peaked at 9.1 percent in mid-2022, its highest level since the early 1980s.

Inflation is the erosion of the purchasing power of money, meaning a unit of currency buys fewer goods and services over time. When inflation is high, that erosion happens quickly, causing short-term pain as households and businesses have to make tough tradeoffs until wages and prices adjust. High inflation also makes it harder to engage in longer-term planning such as investing, borrowing, and saving. That can ultimately affect the performance of the economy should households and businesses start to think that high inflation will persist for a long time.

Conversely, if households and firms anticipate that prices in general are going to fall, that could lead to deflation, an increase in purchasing power, Meyer observes. That could cause negative outcomes for the economy if everyone pulls back on spending and investment to wait for a more favorable economic climate.

As former Fed chairman Alan Greenspan said in a July 1996 FOMC meeting, "Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions." When inflation rates are low, households and businesses can reasonably anticipate what their purchasing power will be and make well-informed choices that are not complicated by trying to discern between what's nominal and what's real.

The Fed wants to reduce inflation to an annual rate of 2 percent. That's the rate it has reaffirmed as the level needed to promote price stability, viewed as a pillar of a healthy economy. Congress has set price stability and maximum employment as the Fed's two mandates in managing the economy.

The Fed's primary tool to regulate the inflation rate is the benchmark interest rate it sets on fed funds, the excess reserves held by financial institutions beyond the amounts needed to meet daily obligations and the sum that banks are mandated to maintain to ensure the safety of consumer deposits. The fed funds rate is the interest rate banks pay for overnight borrowing from reserve funds.

Rates raised to slow economy when inflation is too high

When the Federal Reserve determines inflation is too high, the FOMC typically seeks to slow the economy by raising the interest rate on fed funds. These rate hikes cause banks to tighten lending standards and to raise interest rates on everything from credit cards to home mortgages and business loans. Restricted lending and higher interest rates typically tamp down spending and the reduced demand for goods and services lowers the inflation rate.

In 1980, the Fed took aggressive action to curb inflation, setting the fed funds rate near 20 percent. The intent was to fight an inflation rate approaching 15 percent and unemployment near 10 percent. Paul Volcker, then the Fed chair, oversaw the historic and successful effort but was vilified for years for its effect on many small businesses, according to a 2005 president's message from a former head of the St. Louis Fed.

The recent survey by the US office of YouGov, a London-based market research firm, indicates slightly more than a third of US adults still question this strategy. The survey showed that 38 percent of respondents say that reducing interest rates—lowering the fed funds rate—would reduce inflation.

Those respondents are comprised of 27 percent who think lower interest rates would probably decrease inflation and 11 percent who think lower rates would definitely decrease inflation. The 38 percent figure is within the margin of error of the same question asked in a YouGov poll conducted October 28 through October 31, 2022.

Even for those who understand the policy tools at the Fed's disposal, higher interest rates can sting. A panelist at a Community Listening session hosted in August by the Federal Reserve Bank of Atlanta said some business owners tell her that the cure of higher interest rates is worse than the disease of high inflation.

The session was moderated by Atlanta Fed president Raphael Bostic and Federal Reserve governor Michelle Bowman, who acknowledged that higher interest rates have made it more difficult for businesses to invest and expand. Bostic said the Fed is keeping a close eye on how small businesses are affected.

“Small businesses are more vulnerable in an economic slowdown than larger businesses,” Bostic said. “I'm watching carefully to see how they are dealing with both high inflation and higher interest rates.”

Businesses' loan rates go up before prices come down

Business consultant Anita Davis, founder of Praxis Strategic Solutions, touched on the issue in one panel discussion. The hikes have driven up interest rates on her clients' business loans, she said, but lower inflation has not led to price reductions.

Davis has been tapped into the financing needs of small businesses for almost three decades. She founded the firm in 2016 after a 20-year career in bank lending and said she's helped companies acquire millions of dollars to grow and advised hundreds during the COVID-19 pandemic. Praxis uses the SmallBusiness Administration (SBA) 7(a) program as a primary lending option to help business owners acquire access to capital when they don't meet traditional lending credit requirements.

The program, the SBA's primary funding program for small businesses, guarantees repayment of a major percentage of a loan from an authorized lender to a small business. This encourages the lender to make a loan it otherwise may not originate.

Interest rates on 7(a) loans have almost doubled since the Fed began raising rates in March 2022. Prime interest rates have increased from 3.5 percent in March 2022 to 8.5 percent as of July 2023. SBA lenders typically add 3 percent to the prime interest charged to borrowers, Davis said, and credit card companies typically add a higher markup. The SBA 7(a) variable rate charged to borrowers increased from 6.5 percent in March 2022 to 11.5 percent in August 2023.

The rate hikes have been so painful, Davis said, that some owners have struggled to stay current on business credit card payments, mortgages, working capital lines of credit, and other loans. "The rate of inflation is not their big pain point, but managing their monthly expense budget is," she said.

"Business owners don't talk about or focus on inflation," Davis said after the panel discussion. "During the height of the pandemic, cost of capital was abnormally inexpensive. When rates started to increase, at an unprecedented pace, [it became] difficult to create a budget around the increased payments. Owners know the rate on their line of credit and credit cards has gone up. This is supposed to be the working capital solution that helps the company manage cash flow. A client recently told me the payment on their loan almost doubled, from $2,300 to $4,500. That's what I mean by people are feeling the pain."

Those clients are not seeing relief from declining inflation rates, Davis said.

"They just know rates are increasing and expenses are increasing," Davis said. "I don't hear anybody talking about a correlation between the interest rate increases and inflation getting better. Costs of supplies, payroll, services, food, gas—everything is higher in everybody's estimation and everybody's actualization. Prices are not coming down, except for the price of eggs. This is real life for businesses. The struggle is real."

David Pendered

Staff writer for Economy Matters