We have inflation, so will the Fed cut or raise interest rates?

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:

1. Mortgages become more expensive.
2. Business loans cost more,
3. Credit-card interest rises,
4. Auto loans rise,
5. Landlords face higher financing costs,
6. Companies pass borrowing costs into prices when possible.
7. 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:

1. 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.
2. trump’s main considerations are his family’s fortune, votes, and self-aggrandizement. He receives more money from oil interests than from solar interests.
3. 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

Monetary Sovereignty

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