Inflation, Growth, and Economic Independence: Why the Federal Funds Rate Is Not a Switch

by Kent O. Bhupathi

The federal funds rate is not some simple light switch. You cannot flip it down and flood the economy with prosperity, nor crank it up and instantly stamp out inflation. Yet, time and again, politicians sell it that way.

The latest example comes from the President’s aggressive campaign to slash interest rates by as much as three percentage points, to around 1%. The adminstration insists this will supercharge growth, lower mortgage costs, and save the government trillions in debt payments. But there’s a catch: no serious Fed official supports it.

The effort has become entangled with an even more troubling move. The White House is attempting to remove Federal Reserve Governor Dr. Cook, an accomplished economist whose scholarship spans international and innovation economics. Removing a sitting governor, would be unprecedented. It would also mark a dangerous intrusion of political bias into an institution deliberately insulated from politics.

To understand why this matters, we need to step back. What is inflation? What drives economic growth? And how does the federal funds rate, the obscure-sounding overnight lending rate between banks, actually connect the two?

The answers resist sound bites. That is precisely why treating the Fed’s rate as an on/off switch is both wrong and dangerous.

Inflation: More Than Rising Prices at the Grocery Store

Inflation is often described as prices going up, but that simplification misses the mechanics. At its core, inflation is a sustained increase in the general price level across the economy. The question is always: why?

Over the long run, research is clear that monetary policy matters most. Sustained money supply growth is strongly correlated with inflation trends, and disciplined central banks anchor expectations to keep inflation low. When Paul Volcker’s Fed drove rates near 20% in the early 1980s, it broke the back of double-digit inflation and reestablished credibility in this tool of our Central Bank. That credibility kept U.S. inflation relatively subdued for decades afterward.

Expectations are the quiet engine here. If businesses and households believe the Fed will keep inflation near 2%, they set wages and prices accordingly. Anchored expectations prevent one-off shocks from spiraling into a wage–price loop. This is why the 2021–2022 inflation spike, driven by pandemic stimulus and supply chain snarls, did not morph into a 1970s-style spiral: long-run expectations stayed stable.

In the short run, though, inflation is buffeted by two forces: demand surges and supply shocks:

• Demand-driven inflation occurs when people and businesses spend more than the economy can produce. This happened after the pandemic stimulus, when households, flush with cash, chased too few houses, cars, and vacations.

• Supply-driven inflation comes from sudden scarcity: an oil embargo in the 1970s, semiconductor shortages in 2021, or tariffs that raise import costs today.

The Fed can cool demand-driven inflation by raising rates. But it cannot print semiconductors or pump oil. When inflation comes from supply shocks, tightening rates risks crushing growth without addressing the root cause.

Economic Growth: Beyond Cheap Money

If inflation invites oversimplification, economic growth suffers even more from it. The popular narrative says lower interest rates unleash growth, while higher rates choke it off. But the reality, borne out by decades of research, is more nuanced.

Growth depends on productivity, innovation, labour dynamics, and global forces, not merely the cost of borrowing. Lower rates can create favorable conditions for investment, but they do not guarantee that businesses will expand or that households will actually spend. Productivity gains and technological breakthroughs come from education, infrastructure, and entrepreneurship. Monetary policy can encourage those drivers, but it cannot invent them. If those fundamentals are otherwise lacking in any way, cheap money only serves to cause a bubble.

Empirical evidence supports this. Researchers find that the effects of interest-rate changes are asymmetric: raising rates reliably slows growth, but cutting them does not equivalently accelerate it. Cover (1992) showed that contractionary shocks reduced output significantly, while expansionary shocks had much weaker results. More recent studies attribute this to firm behavior: companies cut output quickly when credit tightens but may hesitate to expand simply because credit is cheaper.

This is why economists often use the metaphor “pushing on a string.” When the economy is weak, banks may be reluctant to lend and households cautious to borrow, blunting the impact of low rates. By contrast, during booms, a modest hike can quickly dampen exuberant borrowing.

This context matters for 2025. The U.S. economy is not in recession. Growth has been steady at around 3% in Q2, unemployment remains near 4%, and labor markets are solid. Slashing rates by three points in such an environment would not spark meaningful new growth. At best, it would add fuel to demand that doesn’t need stoking. At worst, it would reignite inflation, erode investor confidence, and push up long-term borrowing costs as markets price in political interference.

Growth is not the mechanical outcome of cheap credit. It is the product of deeper structural forces that the funds rate influences but cannot control.

The Federal Funds Rate as a Tool, Not a Switch

The record of U.S. monetary history underscores that the funds rate is a powerful but blunt instrument. It influences demand, borrowing costs, and financial markets, but it does so with lags, asymmetries, and collateral effects that defy simple political talking points.

Consider the Volcker era. To tame double-digit inflation in the early 1980s, the Fed pushed the federal funds rate near 20%. The move succeeded in restoring price stability, but at immense cost: unemployment topped 10%, credit-sensitive industries like housing and manufacturing collapsed, and the economy fell into back-to-back recessions. The lesson is stark: high rates can break inflation, but by running the risk of pain.

Econometric research backs this up. Narrative studies and statistical models consistently show that monetary tightening has strong contractionary effects. A 100 basis point hike typically reduces output by 0.7–1.4% within two years, raising unemployment along the way. Romer and Romer (2004) found that policy shocks have “large, relatively rapid, and statistically significant effects” on both output and inflation. More recent high-frequency studies confirm that even small, unexpected rate increases measurably slow growth within 12–24 months.

But these effects are not symmetrical. Rate hikes bite harder than cuts help. A surprise hike raises unemployment quickly; an equal-sized cut barely lowers it. And the state of the economy matters: during expansions, hikes can cool activity effectively, but during downturns, cuts may do little to spark recovery.

The size of changes matters too. Gradual moves often have modest effects, while large and rapid shifts can push the economy into crisis.

This is why the Adminstration’s demands are reckless. A three-point cut would be extreme under any circumstances, but especially in an economy that is presently showing steady growth with relatively low unemployment. It would suggest that Fed policy is driven not by data but by political pressure, risking both inflation and credibility. Powell has put it plainly: cut too soon, and inflation rebounds; cut too late, and you risk unnecessary job loss. Striking the balance requires patience and independence.

If a metaphor must exist, then the federal funds rate is a scalpel, not a light switch. Used carefully, it helps steer the economy toward balance. Used recklessly, it destabilizes the very system it is meant to safeguard.

• Taken together, the chart shows that higher interest rates do not automatically spell recession. Since 2022, the Fed has held policy at its most restrictive stance in decades, with nominal rates fairly recently below 5% and real rates firmly positive. Yet growth has remained in positive territory even as inflation has cooled. The lesson is clear: the link between rate hikes and recession is neither mechanical nor inevitable.

• What the series also highlight is the importance of timing and context. Inflation raced ahead of monetary policy in 2021 to 2022, but its decline followed within the expected lag as monetary tightening took hold. Unlike 2007 to 2009, when output collapsed under financial stress, today’s adjustment reflects supply chains healing and fiscal stimulus fading rather than a collapse in private demand. In this cycle, policy has restored price stability with far less damage to growth, which is evidence that the dynamics of inflation and recession are more nuanced than the simplest narratives allow.

• Recessions defined at: Rethinking Recessions

Why the History Lesson Now?

The President’s stated motive for cutting rates, which is to save on government debt payments, falls outside the Fed’s legal mandate. The Fed’s role, set by Congress, is price stability and maximum employment. It is not to reduce the Treasury’s borrowing costs. That falls to fiscal policy.

Economists warn that subordinating monetary policy to fiscal needs, a dynamic known as “fiscal dominance,” leads to disaster. From Argentina to Zimbabwe, central banks forced to keep rates low for government financing have fuelled runaway inflation and economic collapse.

The United States has avoided this fate largely because of the Fed’s credibility. Its independence reassures households, businesses, and markets that even unpopular decisions, such as raising rates, will be made in service of stability rather than politics. That credibility keeps inflation expectations anchored, which in turn keeps inflation itself under control.

Undermining this independence risks unravelling the very trust that makes monetary policy effective. If markets believe the Fed caves to political pressure, they will demand higher interest rates on U.S. debt, negating the very savings Trump claims to seek.

Conclusion: Independence Over Illusion

The stakes in 2025 are unusually high. Inflation has cooled from its pandemic-era peak but still sits above the Fed’s 2 percent target. Growth is steady and unemployment is low, conditions that hardly call for emergency stimulus. Yet the Administration is pressing for unprecedented rate cuts of three full percentage points while at the same time imposing tariffs that push prices upward. It is, as one analyst observed, like pouring gasoline on a fire.

Markets are not fooled. Long-term Treasury yields have already risen, and the dollar has weakened as investors grow concerned that political interference is undermining the Fed’s credibility. Their response makes the preference clear: they want independence preserved, not sacrificed for short-term political wins. The attempt to remove Dr. Cook only sharpens the danger. Her expertise in international and innovation economics reflects exactly the kind of scholarship the Fed needs in a globalized, fast-changing economy. Silencing voices like hers weakens the institution at the very moment discipline matters most.

Again, the federal funds rate is not some simple and magical light switch. It cannot instantly lower household costs or guarantee faster growth. It is a tool, blunt and powerful, effective only when used with patience and independence. Politicizing it, or treating it as a switch to flip for short-term advantage, risks inflation spirals, financial instability, and a collapse of trust that could take decades to repair.

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