The belief that raising interest rates is the cure for inflation has long been an article of faith. In the early 1980s, when inflation reached nearly 15 percent, then–Fed Chair Paul Volcker famously raised rates to record levels, triggering a major recession. Unemployment reached nearly 11 percent in 1982 and stayed high for years. But inflation stabilized, and Volcker went down in history as the hero who wrecked the economy to save it.
How exactly did Volcker accomplish the job? The conventional view is that raising rates sets off a chain reaction throughout the economy. First, the Fed increases what is known as the federal funds rate—the interest that banks must pay to borrow money from one another, which in turn forces them to charge more for consumer loans. Those higher rates ripple throughout the economy, making it more expensive for people to buy homes and cars, companies to make investments, and developers to finance new construction.
Gradually, everyone starts spending less money. Then, faced with less demand from consumers and less access to capital, companies begin laying off workers. At this point, a vicious cycle takes hold. Laid-off workers pull back even more on spending, which means more layoffs and, in turn, even less spending, until the economy falls into recession. With less money chasing the same amount of goods, prices finally come under control. The dread beast inflation is defeated.
This is the canonical story of what happened in the 1980s. And so, when inflation hit three years ago, and the Fed reached for the one tool in its toolbox, nearly every expert predicted an ’80s-style economic meltdown. A Bloomberg Economics model forecast a 100 percent chance of a recession by October 2023, and the Fed itself projected hundreds of thousands of job losses. The experts were wrong. Over the course of 2023, the economy boomed, unemployment remained historically low, and consumers kept spending. Despite all that, inflation fell anyway, from a peak of 9 percent in June 2022 to about 3 percent by the end of 2023.
We have a bit of a mystery on our hands. The Fed raised rates, and inflation fell—but the other steps in the chain reaction never happened. Did higher interest rates cause inflation to decline, or was that a coincidence? Multiple studies have concluded that the inflation spike was mostly caused by pandemic-shutdown ripple effects. Perhaps the subsequent decline was just a natural consequence of things returning to normal.