The Fed Called Inflation ‘Transitory,’ Then It Changed Course and Found a ‘Golden Path’

Inflation is coming down and a once widely expected recession never hit – two grand economic achievements that made 2023 the Year of the Fed.

But the Federal Reserve's laudable success marks a turnaround from an equally grand folly when inflation first surged in 2021. Fed Chairman Jerome Powell, and other policymakers and economists, then called the sudden runup in inflation "transitory."

“The characterization of inflation as transitory is probably the worst inflation call in the history of the Federal Reserve, and it results in a high probability of a policy mistake,” said Mohamed El-Erian, Allianz chief economic advisor, former Pimco CEO, and president of Queens’ College, told CBS’ “Face the Nation" in December 2021.

“So the Fed must quickly, starting this week, regain control of the inflation narrative and regain its own credibility,” El-Erian said.

The Fed has avoided a policy mistake. In 2023, it treaded gingerly through an economic minefield, slowly raising its key interest to a 22-year high of 5.25% to 5.5% and watching for explosions along the way. Four of its 11 rate hikes since March 2022 came in 2023, along with four "wait-and-see" pauses in its inflation-fighting campaign.

The Fed is now on track to guiding the U.S. economy to a soft landing, a feat once considered nearly impossible. Here's how the Fed's eight rate-setting meetings went in 2023:

January

The Fed entered 2023 with its key rate at 4.25% to 4.5%, up from what's now an almost-unimaginable rate of zero at the beginning of 2022. The sharp rise in rates had most economists predicting a recession.

Nevertheless, the central bank's rate-setting Federal Open Market Committee raised its key rate a quarter point to 4.5% to 4.75% at its Jan. 31-Feb. 1 meeting. Inflation, as measured by the Consumer Price Index, was running at an annualized rate of 6.4%, down from its peak of 9.1% in June 2022, but well above the Fed's 2% target.

"Russia's war against Ukraine is causing tremendous human and economic hardship and is contributing to elevated global uncertainty," the FOMC said in its statement.

March

Little did the Fed know its interest rate hikes would devastate a handful of regional banks and put many others on shaky ground.

On March 10, regulators seized Silicon Valley Bank. The bank's bond investments declined as interest rates rose, and customers, getting word on social media, rushed to withdraw their uninsured deposits. At the time it was the nation's second-largest bank failure after Washington Mutual Bank in the 2008 financial crisis. New York-based Signature Bank followed on March 12. A smaller California bank, Silvergate Bank, announced on March 8 that it would liquidate.

Despite these frightening developments, the Fed forged ahead. At the FOMC's March 21-22 meeting, it raised its rate from 4.75% to 5%.

"The U.S. banking system is sound and resilient," the FOMC insisted in its statement. "Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain." 

May

On May 1, First Republic Bank topped Silicon Valley Bank as the second-largest bank failure.

Worries about a financial contagion that would take down many other region banks dominated headlines. But the Fed held firm to its statement that banks were essentially "sound and resilient," and it raised its key rate to 5% to 5.25% at its May 2-3 meeting.

CPI inflation was now down to 4%, but elevated prices had deeply darkened consumers' moods, according to a Fed survey.

Nevertheless, a predicted slowdown in the economy and rise in the unemployment rate weren't manifesting as so many economists had predicted.

"Economic activity expanded at a modest pace in the first quarter," the FOMC statement read. "Job gains have been robust in recent months, and the unemployment rate has remained low."

June

A pandemic recovery, stubborn inflation, a war in Ukraine and economic resilience in the face of rising interest rates presented a set of economic dynamics no economist had ever seen before

At its June 13-14 the Fed took its first pause in the rate hiking cycle, setting off wide speculation that it was done raising rates. Powell, however, warned that it was just a pause and that more rate hikes could be coming depending on the path of inflation.

As inflation declined, Fed officials said their margin for a cataclysmic economic error narrowed. If interest rates rose too high, or stayed at elevated levels for too long, they risked plunging the economy into a recession. If they didn't raise rates high enough, they risked a resurgence in inflation.

But inflation dropped precipitously in June to 3% from 4% in May, demonstrating that the Fed's rate hikes were working.

"Considering how far and how fast we have moved, we judged it prudent to hold the target range steady to allow the Committee to assess additional information and its implications for monetary policy," Powell said.

He also signaled consecutive rate hikes in the future were not off the table.

On the banking front, the Fed announced its most recent stress tests showed the banking system was indeed "sound and resilient." A much-feared banking crisis never came.

July

As if to prove a pause was not an end to the Fed's rate-hiking cycle, policymakers voted to raise their rate to 5.25% to 5.5% at their July 25-26 meeting, a 22-year high.

The first of several reports showing unexpected growth showed that the economy grew at 2% in the first quarter, much higher than the 1.3% growth initially recorded. The resilient economy threatened to keep inflation sticky, and indeed the CPI bounced up to 3.2% in July.

Economists and traders were increasingly betting that the Fed was done cutting rates. And Goldman Sachs predicted the Fed's efforts to tame inflation would not spark a recession.

“Looking ahead, we will continue to take a data-dependent approach in determining the extent of any policy firming that may be appropriate,” Powell said, kicking off a "wait-and-see" approach that would define the rest of the year for the Fed.

The path forward, though, was hardly obvious. In an Aug. 25 speech, Powell stressed the policymakers faced continued uncertainty. “We are navigating by the stars under cloudy skies."

September

The Fed took its second pause at its Sept. 19-20, but Powell continued to warn that more hikes could be on the way.

"We're prepared to raise rates further if appropriate," he said.

As oil prices spiked to nearly $100 a barrel, Fed Governor Michelle Bowman, Boston Fed President Susan Collins and San Francisco Fed President Mary Daly, warned the inflation fight wasn't over.

Indeed, inflation ticked higher to 3.7% in September.

"I continue to expect that further rate hikes will likely be needed to return inflation to 2% in a timely way," Bowman said. 

October

The central bank's interest rate hikes were increasingly taking a toll on consumers with mortgage rates approaching 8% and credit card rates hitting record highs.

Treasury yields rose to their highest levels since July 2007. The yield on the 10-Year Treasury, a benchmark for financial markets and consumer loans, crossed the 5% threshold.

The Fed again held its key rate steady at its Oct. 31-Nov. 1 meeting, with Powell reiterating his stance that more hikes could come, depending on the data.

But Treasury yields started to pull back and the stock market rallied as investors bet the Fed was truly done raising rates.

Also of note in October, the Fed stopped using the word, recession.

December

Again, no rate hike as the Fed ended its final meeting of the year on Dec. 12-13, with its key rate still at 5.25% to 5.5%.

Powell continued to wax about possible rate hikes. “Inflation has eased from its highs, he said. "But inflation is still too high, ongoing progress in bringing it down is not ensured,  and the path forward is uncertain."

And New York Fed President John Williams on Dec. 15 said the Fed has not begun discussing when it might start cutting rates.

Still, virtually, no one expects the Fed to raise raises again. The market is largely betting on rate cuts as soon as March, according to the CME FedWatch Tool, based on Fed funds futures trading. And the Fed's dot-plot has signaled a willingness to cut rates to between 4.25% and 4.75% in 2024.

These expectations have even begun to benefit consumers with mortgage rates falling to nearly 7%.

So the Fed ends the year with inflation down to 3.1%, as measured by November's CPI; the unemployment rate at 3.7% in November, extending the longest run below 4% since the 1960s; the economy holding strong, even posting staggering 5.2% growth in the third quarter; and the stock market trading around record highs.

"The tone today was almost as though they are expecting the perfect landing, well beyond expectations of a soft landing," said Alex McGrath, chief investment officer for NorthEnd Private Wealth in Greenville, S.C. following Powell's December news conference. "Equity markets are clearly overjoyed."

January 2024

The economy isn't likely to sustain the blockbuster growth it logged in the third quarter. The Fed estimates economic growth will end the year at an annualized pace of 2.6% and slip to 1.4% in 2024. There are already some signs the economy is cooling.

Central bank economists project inflation will fall to 2.4%, as measured by the Core Personal Consumption Expenditures Index, which excludes volatile food and energy prices. That's almost down to its 2% target.

Lower inflation and a slowing economy may mean the Fed can start cutting rates, as expected. The mission appears almost accomplished.

Most Fed policymakers have yet to take a victory lap, but in a November CNBC interview, Chicago Fed President Austan Goolsbee crowed that the decline in inflation has marked one of the fastest in U.S. history, and it came with a much lower-than-expected cost to the economy.

"There is a possibility of the golden path, that we get inflation down without a recession," he said.