A customer shops at a grocery store in Miami, Florida on February 10, 2022. The Labor Department said consumer prices rose 7.5% last month from 12 months earlier, the sharpest year-on-year increase since February 1982.
Joe Raedle | Getty Images
The view that higher interest rates will help stamp out inflation is essentially an article of faith based on the long-held economic gospel of supply and demand.
But how does it really work? And will it work this time when inflated prices seem at least partly beyond the reach of conventional monetary policy?
It is this dilemma that confuses Wall Street and makes markets volatile.
In normal times, the Federal Reserve is viewed as the cavalry capable of quelling rising prices. But this time the central bank will need some help.
“Can the Fed bring down inflation on its own? I think the answer is ‘no,'” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “They can certainly help contain the demand side through higher interest rates. But it won’t offload container ships, it won’t reopen manufacturing capacity in China, it won’t hire the long-distance truckers we need to get things across the country.”
Still, policymakers will try to slow the economy and curb inflation.
The approach is two-pronged: the central bank will also raise short-term interest rates at the same time Reduction of more than $8 trillion in bonds it has accumulated over the years to keep money flowing through the economy.
Under the Fed’s blueprint, the translation of these measures into lower inflation looks something like this:
The higher interest rates make money more expensive and borrowing less attractive. That, in turn, is slowing demand to catch up with supply, which has lagged sharply during the pandemic. Less demand means retailers are under pressure to lower prices to entice people to buy their products.
Potential impacts include lower wages, a halt or even decline in rising house prices and, yes, a drop in valuations for a stock market that has held up pretty well so far in view of rising inflation and the consequences of the war in Ukraine.
“The Fed has been quite successful in convincing markets that they are watching the ball and long-term inflation expectations have been kept under control,” Baird said. “As we look ahead, this will continue to be the main focus. That’s something we’re monitoring very closely to make sure investors don’t lose confidence [the central bank’s] Ability to keep long-term inflation under control.”
Consumer inflation rose at an annual pace of 7.9% in February and probably rose even faster in March. According to the Labor Department, gasoline prices rose 38% during the 12-month period, while groceries rose 7.9% and housing costs rose 4.7%.
There is also a psychological factor in the equation: inflation is seen as a kind of self-fulfilling prophecy. If the public thinks the cost of living will increase, they adjust their behavior accordingly. Businesses raise the prices they charge and workers demand better wages. This flush and repeat cycle can potentially fuel inflation even further.
That’s why Fed officials not only approved their first rate hike in more than three years, but they did too talked hard about inflationto dampen future expectations.
It’s a combination of these approaches — concrete moves in interest rates plus “forward guidance” about where things are going — that the Fed hopes will bring inflation down.
“You have to slow growth,” said Mark Zandi, chief economist at Moody’s Analytics. “If they take a little steam off the stock market and credit spreads widen and underwriting standards get a little tighter and house price growth slows down, all of these things will contribute to a slowdown in demand growth. That’s a key part of what they’re trying to do here, trying to tighten financial conditions a bit so demand growth slows and the economy slows down.”
Financial conditions are currently considered easy by historical standards, but are becoming increasingly tight.
Indeed, there are many moving parts, and policymakers’ biggest fear is that as they curb inflation, they won’t collapse the rest of the economy at the same time.
“They need a bit of luck here. If they get it, I think they’ll make it,” Zandi said. “If they do, inflation will moderate as supply-side problems ease and demand growth slows. If they are unable to sustain inflation expectations, then no, we are in a stagflation scenario and they will have to drag the economy into recession.”
(Note: Some at the Fed don’t believe expectations matter. This much-discussed white paper by one of the central bank’s economists in 2021 expressed doubts about the impact and said the belief rests on “extremely shaky foundations”.)
Those who were present during the last serious phase of stagflation in the late 1970s and early 1980s remember these effects well. With prices galloping, then-Fed Chairman Paul Volcker led an effort to raise the fed funds rate to nearly 20%, plunging the economy into recession before taming the inflation monster.
Needless to say, Fed officials want to avoid a Volcker-like scenario. But after months insisted inflation was “temporary” A central bank late to the party is now forced to tighten quickly.
“Whether what they have planned is sufficient or not, we will find out in time,” Paul McCulley, former chief economist at bond giant Pimco and now a senior fellow at Cornell, told CNBC in an interview on Wednesday. “What they are telling us is if it’s not enough we will do more, implicitly acknowledging they will increase downside risks to the economy. But they have their Volcker moment.”
Certainly, the odds of a recession appear slim for now, even with the current inversion of the yield curve that often signals downturns.
One of the most widespread beliefs is that employment, and in particular the demand for labor, is fair too strong create a recession. According to the Department of Labor, there are currently about 5 million more job openings than workers, reflecting one of the tightest job markets in history.
But this situation is contributing to rising wages, which rose 5.6% yoy in March. Goldman Sachs economists say the job gap is a situation the Fed must address or it risks protracted inflation. The company said the Fed may need to cut gross domestic product growth to the 1% to 1.5% annual range to rein in the job market, implying an even higher policy rate than markets’ currency prices — and less room for maneuver for the economy into at least a shallow downturn.
So it’s a delicate balance for the Fed as it seeks to use its monetary arsenal to drive prices down.
Joseph LaVorgna, chief Americas economist at Natixis, is concerned that a shaky growth picture could now test the Fed’s resolve.
“Outside of a recession, you’re not going to bring inflation down,” said LaVorgna, who was chief economist at the National Economic Council under former President Donald Trump. “It’s very easy for the Fed to talk hard now. But if you go a few steps further and suddenly the employment picture shows weakness, will the Fed really keep talking hard?”
LaVorgna observes the steady growth of prices that are non-cyclical and rising at the same rate as cyclical products. They may also be less subject to interest rate pressures and may rise for reasons unrelated to loose policy.
“If you’re thinking about inflation, you need to curb demand,” he said. “Now we have an offer component to it. They can’t do anything about supply, so they may have to compress demand more than they normally would.