After 10 consecutive interest rate hikes, Federal Reserve officials announced on Wednesday that they would pause their fight against inflation to figure out whether the US economy was fully absorbing all that harsh medicine.
Following the policy announcement, Fed Chair Jerome Powell noted that rate hikes typically filter through the economy with "uncertain lags." In other words, the Fed has been playing an (educated) guessing game, taking action before it understands the results.
But the trick is the Fed doesn't even know how long these lags may last between a rate hike and its effect on inflation. Now it wants to see some hard evidence.
What's happening: As much as Federal Reserve officials wish they could, they can't just wave a wand and lower inflation rates. Instead there's a flow of monetary policy through the economy.
Here's how the system works: First, the Fed raises interest rates for overnight loans between financial institutions.
Those hikes then filter through the rest of the economy as banks make up for pricier loans by increasing the cost of lending for households and businesses.
That makes household savings drop. It also makes businesses less profitable, and they typically hire less. That takes money out of the economy, and eventually spending will stall. Less demand for goods reduces incentives to raise prices and inflation rates will fall.
But there are a large number of factors that can get in the way of this system working properly, The economy is complex, things get especially fuzzy when you try to pinpoint the timing and size of an interest rate hike's economic impact.
Timing the lag: "It's an art, not a science," said Jack McIntyre, portfolio manager at Brandywine Global, of the US central bank's inflation-busting objective. Even in a normal economic cycle, "there's no magic equation of 'if I raise interest rates by one percentage point, inflation will fall by a certain amount,'" he said.
And this is not a normal economic cycle. Pandemic relief programs pumped extraordinary sums of money into the US economy and Covid-19 significantly altered the labor market. There's no guidebook for how to deal with that, said McIntyre.
Another complication in determining how long the Fed's actions will take to fix inflation: Federal Reserve officials are raising interest rates in a very different communications landscape than they have before.
This is the era of social media, when news (and rumors) spread and swing markets at a rapid pace.
"It's a challenging thing in economics," Powell said in his press conference. "It's sort of standard thinking that monetary policy affects economic activity with long and variable lags." But these days, he said, "tightening happens much sooner than it used to in a world where news was in newspapers and not, you know, not on the wire."
This is the first major hiking cycle in the age of social media and "interest sensitive spending is affected very, very quickly," said Powell. "Financial conditions begin to tighten well in advance of actual rate hikes."
A confidence problem: Financial markets have always tried to be forward looking and react to expectations, and banks regularly try to adjust credit policy against potential headwinds, said Yung-Yu Ma, chief investment strategist at BMO Wealth Management.
The difference here is that there's more tangible economic data made available than ever before. "I don't necessarily agree strongly with what Chairman Powell said," commented Ma. "I don't think it's that different than it used to be in terms of the speed with which these things take place. I do think however, it's a bit less haphazard, and people can react to specific data points more than they could in the past."
In other words, analysts, investors and business leaders are able to consider the same economic data as Fed policymakers in real time. That means they're able to draw their own conclusions about the trajectory of inflation rates.
For the Federal Reserve, which counts public confidence as one of its most powerful tools, that spells more uncertainty ahead.
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