The Fed traditionally raises interest rates to counter inflation. But there are opposing forces at work.
Raising rates makes things more expensive, which by definition is inflationary. But raising rates may inhibit borrowing, which can reduce demand, which can ease scarcity. That’s the hypothesis. What is the stronger effect?
That is one of the central unresolved practical questions in macroeconomics: Higher interest rates simultaneously create inflationary forces and disinflationary forces. The issue is which dominates, under what conditions, and with what time lag.
The inflationary side of rate hikes: Raising rates directly raises costs throughout the economy.
Examples:
- Mortgages become more expensive.
- Business loans cost more,
- Credit-card interest rises,
- Auto loans rise,
- Landlords face higher financing costs,
- Companies pass borrowing costs into prices when possible.
- Government interest payments rise.
Interest payments turn into income for households, banks, and bondholders, all of which boost demand—or in “Fed speak,” heat up the economy.
In the 1970s, the U.S. saw sluggish growth, rising unemployment, and high inflation all at once. This surprised economists, as postwar models assumed inflation and unemployment moved in opposite directions.
Instead, both rose together, driven by factors like oil shocks, energy shortages, supply disruptions, geopolitical tensions, and wage-price spirals.
The Fed responded with very high interest rates under Paul Volcker, but this caused severe recession and unemployment that negatively affected the 95% lower wealth group while growing the fortunes of the 5% greater wealth people.
By contrast, from roughly the 1990s through pre-COVID years, the U.S. experienced a long economic expansion with relatively low unemployment, combined with low and stable inflation, technological productivity gains, globalization,
cheap imports, and strong supply growth.
That period contradicted the simplistic idea that low unemployment produces inflation. In fact, central banks repeatedly underestimated how low unemployment could go without inflation accelerating.
Higher rates therefore increase certain prices mechanically. Numbers 1-6 (ab0ve) reduce GDP, i.e., are recessive. Number 7 increases GDP, therefore, is expansive. Note however that recession is not the opposite of inflation, nor is expansion equal to inflation. We can have inflation together with recession (“stagflation”)
In short, the Fed views inflation as a “too-much-money” problem and so, tries to cure inflation by recessing the economy. The strange idea is that if you make the vast majority of the people poorer, they will buy less food and oil (the main drivers of inflation), while high interest rates make wealthy bond owners richer.
Which effect is stronger? Historically, the answer appears to be that interest rate increases are mostly inflationary, especially for housing, financing costs, and business costs, and do nothing to increase the supply of energy and food.
Inflation is driven mainly by oil shocks, supply-chain breakdowns, war, food shortages, housing shortages,
pandemic disruptions. In those cases, raising rates does not produce more oil, more food, more chips, more housing, or more shipping capacity.
It may even worsen supply by discouraging investment.
For example, post-pandemic inflation involved major supply disruptions, energy shocks, and logistics problems. Rate hikes could not solve those. That is why Biden successfully fought inflation by passing legislation that would increase the supply of energy (especially renewable), as well as supply chain, infrastructure, and other shortages.
Fossil-fuel shocks repeatedly drive inflation, so reducing dependence on volatile oil and gas markets could reduce future inflation vulnerability.
(Trump has increased, decreased, increased, decreased, and increased tariffs as his whimsical approach to economic planning and inflation.)
Look at this graph:
1. If energy shortages repeatedly precede major inflation episodes, why do we raise interest rates to reduce demand, rather than trying to expand the energy supply?
2. Why has Trump reduced support for renewables like solar, wind, geothermal, and water, and instead focused on coal and oil that pollute our air and water, and will become increasingly expensive as sources dwindle?
3. What are the economic effects of reducing demand (“cooling” the economy)?
Answers:
- If your only tool is a hammer, every problem looks like a nail to be hammered. The Fed’s primary tool is interest rates, so every supply problem asks for a demand solution.
- trump’s main considerations are his family’s fortune, votes, and self-aggrandizement. He receives more money from oil interests than from solar interests.
- Reducing the demand for oil, housing, food (food??), cars, infrastructure, R&D, etc., by definition, is recessive, both short term and long term. Economic growth requires increased spending. (GDP=Total Spending + Net Exports).
Rodger Malcolm Mitchell
Twitter: @rodgermitchell
Search #monetarysovereignty
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MUCK RACK: https://muckrack.com/rodger-malcolm-mitchell;
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#Monetary Sovereignty - Mitchell 
The motto for today’s economists: “It never works, and mathematically cannot work, but everyone tells me it works, so let’s keep doing it, only more so, until it works.”
In that vein, Trump and his tariffs would make a perfect economist.
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Thank you, Rodger. Well said overall.
I recall that up until 2018-2019 or so, you had previously believed that raising interest rates was a good and effective way to fight inflation (at least better than using taxes to do so), as did I at least briefly as well.
While Ellen Brown had pretty much always opposed it, as did practically everyone involved in MMT as well.
So it seems that MS and MMT have largely converged on that topic, which is a good thing on balance IMHO. We know now that shortages of goods and services are the real root cause of inflation, so raising interest rates will likely do more harm than good in that regard.
And that Milton Friedman was very wrong indeed when he said that “inflation is always and everywhere a monetary phenomenon”.
One “success” story the interest rate-hikers luuurrrve to lean on is how the FERAL Reserve cured stagflation in the early 1980s by raising interest rates so high that they deliberately engineered a deep enough recession to destroy aggregate demand and squeeze inflationary expectations out of the system.
That is at least partly true, and such brute-forcing was of course followed by the massive “deficit” spending of the Reagan administration as well. But the Bank of Canada basically did the same thing with their interest rates in their country, except even higher and for longer, and they were not so lucky in that regard.
To the extent that there is any benefit to doing so as a “break glass in case of emergency” last resort, such hikes need to be short and sharp, and lowered as soon as inflation is sufficiently beaten down, as it is at best a razor-sharp, double-edged sword.
Otherwise, best to avoid doing so altogether, and the government should strike the root of the problem, and (counterintuitively) spend more money to incentivize the production of goods and services that are in short supply.
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