A customer shops at a grocery store on February 10, 2022 in Miami, Florida. The Labor Department said consumer prices jumped 7.5% last month from 12 months earlier, the biggest year-over-year increase since February 1982.
Joe Raedle | Getty Images
The view that higher interest rates help eradicate 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 around, when inflated prices seem at least partially beyond the reach of conventional monetary policy?
It is this dilemma that makes Wall Street confused and the markets volatile.
In normal times, the Federal Reserve is seen as the cavalry coming to quell soaring prices. But this time, the central bank is going to need help.
“Can the Fed bring inflation down on its own? I think the answer is ‘no,'” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “They can certainly help dampen demand by raising interest rates. But that’s not going to unload container ships, it’s not going to reopen production capacity in China, it’s not going to hire long-haul truckers. we need to get things across the country.”
Still, policymakers will try to slow the economy and bring inflation under control.
The approach is two-pronged: the central bank will raise benchmark short-term interest rates while cutting the more than $8 trillion in bonds it has accumulated over the years to help maintain circulation of money in the economy.
According to the Fed’s plan, the transmission from these stocks to lower inflation looks like this:
Higher rates make money more expensive and borrowing less attractive. This, in turn, is slowing demand to catch up with supply, which has lagged badly throughout the pandemic. Less demand means traders will be under pressure to reduce prices to entice people to buy their products.
The potential effects include lower wages, a halt or even a decline in soaring house prices and, yes, lower valuations in a stock market that has so far held up quite well in the face of soaring l inflation and the fallout from the war in Ukraine. .
“The Fed has been reasonably successful in convincing markets that they have their eye on the ball, and long-term inflation expectations have been brought under control,” Baird said. “As we look to the future, this will continue to be the primary focus. It is something we are watching very closely, to ensure that investors do not lose confidence in [the central bank’s] ability to contain inflation over the long term.
Consumer inflation rose at an annual rate of 7.9% in February and likely increased at an even faster rate in March. Gasoline prices jumped 38% over the 12-month period, while food rose 7.9% and housing costs rose 4.7%, according to the Labor Department.
The waiting game
There is also a psychological factor in the equation: inflation is seen as a kind of self-fulfilling prophecy. When the public thinks the cost of living will be higher, they adjust their behavior accordingly. Companies raise their prices and workers demand better wages. This rinse and repeat cycle can potentially lead to even higher inflation.
That’s why Fed officials not only approved their first rate hike in more than three years, but also spoke strongly about inflation, in an effort to dampen future expectations.
In that vein, Fed Governor Lael Brainard – a long-time proponent of lower rates – delivered a speech on Tuesday that stunned markets when she said policy needed to be much tougher.
It’s a combination of these approaches – tangible moves in key rates, plus “forward guidance” on where things are headed – that the Fed hopes will bring inflation down.
“They need to slow growth,” said Mark Zandi, chief economist at Moody’s Analytics. “If they take some of the steam out of the stock market and credit spreads widen and underwriting standards get a little tighter and housing price growth slows down, all of those things will contribute to a slowdown demand growth. That’s a key part of what they’re trying to do here, try to tighten financial conditions a bit so that demand growth slows down and the economy moderates.”
Financial conditions by historical standards are currently considered loose, although they are tightening.
Indeed, there are a lot of moving parts, and policymakers’ biggest fear is that by curbing inflation, they won’t bring down the rest of the economy at the same time.
“They need a bit of luck here. If they get it, I think they can do well,” Zandi said. “If they do, inflation will moderate as supply issues ease and demand growth slows. If they are unable to keep inflation expectations pegged, then no, we’re going into a stagflation scenario and they’re going to have to pull the economy into recession.”
(Note: some at the Fed don’t believe expectations matter. This widely discussed white paper by one of the central bank’s own economists in 2021 expressed doubts about the impact, saying the belief rests on “extremely fragile foundations”.)
People around the last serious episode of stagflation, in the late 1970s and early 1980s, remember this impact well. In the face of soaring prices, then-Fed Chairman Paul Volcker led an effort to drive the federal funds rate up to nearly 20%, plunging the economy into a recession before taming the inflationary beast.
Needless to say, Fed officials want to avoid a Volcker-type scenario. But after months of insisting inflation was “transitional”, a late-party central bank is now being forced to tighten quickly.
“Whether what they’ve plotted is enough or not, we’ll 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 Wednesday. “What they’re telling us is that if that’s not enough, we’ll do more, which implicitly implies they’ll increase the downside risks to the economy. But they’re living their Volcker moment.”
Admittedly, the chances of a recession seem low at the moment, even with the momentary inversion of the yield curve which often portends slowdowns.
One of the most widely held beliefs is that employment, and more specifically the demand for workers, is simply too strong to generate a recession. According to the Labor Department, there are about 5 million more job openings than there are available workers, reflecting one of the tightest job markets around. Of the history.
But that is contributing to soaring wages, which rose 5.6% from a year ago in March. Goldman Sachs economists say the jobs deficit is something the Fed must address or risk continued inflation. The company said the Fed may need to bring gross domestic product growth back to the 1% to 1.5% annual range to slow the job market, implying an even higher policy rate than stock prices. currencies in the markets – and less leeway for the economy. swing into at least a mild recession.
“That’s where you get the recession”
It is therefore a delicate balance for the Fed, which is trying to use its monetary arsenal to drive down prices.
Joseph LaVorgna, chief economist for the Americas at Natixis, worries that a wobbly growth picture could now test the Fed’s resolve.
“Outside of the recession, you’re not going to bring inflation down,” said LaVorgna, who served as chief economist at the National Economic Council under former President Donald Trump. “It’s very easy for the Fed to talk tough now. But if you do a few more hikes and all of a sudden the jobs chart shows weakness, is the Fed really going to keep talking tough?”
LaVorgna observes the steady growth of prices which are not subject to economic cycles and which increase as rapidly as cyclical products. They may not be as pressured by interest rates and are rising for reasons unrelated to loose policy.
“If you’re thinking about inflation, you have to slow down demand,” he said. “Now we have a supply element. They can’t do anything about supply, so they might have to compress demand more than they normally would. That’s where you get the recession.”