New York CNN
After leaving interest rates unchanged for the first meeting since March 2022, the Federal Reserve has reached a critical fork in its road.
A recession could result from one of two paths: continuing to raise rates in order to reduce inflation. This would occur if the Fed raises rates too much, leading businesses and consumers alike to drastically cut their spending.
If we take the other route -- taking longer to assess the health of the economy -- it could reverse the progress made towards the Fed's 2% inflation target. This is because consumers may not have a good reason to stop their spending, which could lead to higher prices.
CME FedWatch Tool shows that traders are confident the Fed will choose the first option during its meeting this coming week. There's less consensus on which direction the Fed will go at future meetings.
In 2006, the Fed faced a similar situation
Fed officials were concerned that continuing to raise rates could harm the economy. They raised interest rates 17 times in a row between June 2004 and 2006.
They were beginning to see signs of a housing slump, but it was not yet clear how severe it would be. According to the Fed’s preferred inflation indicator, the Personal Consumption Spending price index, inflation showed signs of improvement, but was still above the central banks' target.
Continue the pause
After the quarter-point rate hike in June, the Fed made its initial decision to cease raising rates. Many Fed officials were concerned that raising rates after such a short six-week break would send the wrong message.
According to an archived Fed transcription, Michael Moskow, former Chicago Fed President, stated at the Fed's meeting in August 2006 that he paused for incoming data. I believe it takes more than one meeting worth of data to evaluate that. He added that if the Fed moved today, that would send a message that it was only reacting to small bits of information.
Officials warned that they might end up tightening the screws too much, given the length of time it takes to feel the effects across the economy.
They agreed, however, that they would not hesitate to raise rates again if the inflation rate started to rise. Officials stressed that it was important to keep a line on their policy statement for the September meeting explaining their decision to maintain pause, and leave the door open to possible more rate increases.
The Fed held off raising rates until 2015 when it felt that the economy was significantly recovered from Great Recession.
Why you should hike again
Officials expressed concern that by leaving rates unchanged when inflation was higher than their target, it could lead to a persistently high level of inflation.
This could occur if consumers become accustomed with higher inflation and businesses continue to increase prices. In the future, more rate increases may be needed to bring inflation down.
Cathy Minehan said, 'If the inflation is less persistent, and we assume that it isn't and take a more conservative policy stance then inflation should retreat rapidly and help to shore up our credibility', during the September 2006 meeting. "Choosing a weaker position and being incorrect about it could prove costly."
It wasn't yet enough for her to vote in favor of an increase. Jeffrey Lacker was the only official at that time who voted in favor of raising rates.
"Tolerating an increase in inflation is a grave mistake,' I believe. He said that the 1970s were a good example of this. Lacker remained the only Fed official to favor raising interest rates up until the end of his term.
In September 2007, after the rate had remained unchanged since the June 2006 increase, the officials unanimously decided to cut the interest rates by a half-point.
What can the Fed learn from 2006?
Athanasios orphanides, former advisor to the European Central Bank and the Federal Reserve, said that it is common for the Fed's to use past experience as a guide, since this is the only thing a central bank can rely on.
He said that the Fed will certainly be reviewing its actions between 2005 and 2007.
"Both today and then, in 2006, it was a question of tightening policy because the committee deemed inflation to be inconsistent with price stabilty."
Austan Goolsbee said, in an interview conducted last month, that the Fed was experiencing many deja vus from 2006. There are, however, important distinctions.
The recovery from Covid's recession 'doesn't look anything like previous business cycles,' he stated in an interview at The Wall Street Journal Global Food Forum last month. Historical analogies will always be imperfect for the current situation.
William English, an ex-Fed staffer who now works at Yale University, said that it can be useful to review past decisions in order to see what factors were at play, and what surprises came along with policy decisions.
He added that the 2006 experience will not be enough to guide officials in the correct direction. It's easy to imagine that the Fed would find it necessary to increase rates further, before stopping, and then reducing them later. The uncertainty is a double-edged sword, as the Fed may end up cutting rates quickly.
He said that the Fed would be looking back at past turning points in interest rates to help it decide how to proceed.
According to him, the tightening cycle that was most similar was between 1994 and 1995.
He said that, 'as it was this time, the Committee waited until the economy was in a good place before raising rates. Then, they raised rates quickly with moves of 50 and 75 basis points. Fed officials chose to take a break in the fall 1994 before raising rates again in the winter. They cut rates shortly afterward, but not as much as in 2008.