A customer shops at a grocery store on February 10, 2022 in Miami, Florida. The Labor Department announced that consumer prices rose 7.5% last month compared to the previous 12 months, the steepest year-over-year increase since February 1982.
Joe Raedle | fake images
The view that higher interest rates help quell inflation is essentially an article of faith, based on the long-standing economic gospel of supply and demand.
But how does it really work? And will it work this time, when inflated prices seem at least partially beyond the reach of conventional monetary policy?
It is this dilemma that has Wall Street confused and markets volatile.
In normal times, the Federal Reserve is seen as the cavalry that comes to quell skyrocketing prices. But this time, the central bank will need help.
“Can the Fed reduce 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 control the demand side through higher interest rates. But it’s not going to unload container ships, it’s not going to reopen production capacity in China, it’s not going to hire the long-haul truckers that we need to get things done.” the country.”
Still, policymakers will try to slow the economy and control inflation.
The approach is two-pronged: the central bank will raise short-term benchmark interest rates and at the same time reducing the more than $8 billion in bonds it has built up over the years to help keep money flowing through the economy.
Under the Fed’s plan, the pass-through of those actions to lower inflation goes something like this:
Higher rates make money more expensive and loans less attractive. That, in turn, slows demand to catch up with supply, which has lagged far behind during the pandemic. Less demand means merchants will be under pressure to cut prices to entice people to buy their products.
Potential effects include lower wages, a spike or even a drop in home price growth and, yes, a decline in property valuations. a stock market that has held up pretty well so far in the face of galloping inflation and the consequences of the war in Ukraine.
“The Fed has been reasonably successful in convincing markets to be vigilant and long-term inflation expectations have been kept in check,” Baird said. “Looking ahead, that will continue to be the main focus. It’s something we’re watching very closely, to make sure investors don’t lose faith in [the central bank’s] ability to control inflation in the long run.
Consumer inflation rose at a rate of 7.9% per year in February and probably increased at an even faster rate in March. Gasoline prices rose 38% during the 12-month period, while food prices rose 7.9% and housing costs 4.7%, according to the Labor Department.
There is also a psychological factor in the equation: inflation is believed to be a kind of self-fulfilling prophecy. When the public thinks the cost of living will be higher, they adjust their behavior accordingly. Companies raise the prices they charge and workers demand better wages. That rinse-and-repeat cycle can potentially drive inflation even higher.
That’s why Fed officials not only approved their first rate hike in more than three years, but also they’ve talked tough about inflationin an effort to cushion future expectations.
It is a combination of these approaches (tangible moves in policy rates, plus “future guidance” on where things are headed) that the Fed hopes will bring inflation down.
“They need to curb 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 home price growth slows, all of those things will contribute to a slowdown in the demand growth. That is a key. part of what they’re trying to do here, try to get financial conditions to tighten a little bit so that demand growth slows down and the economy moderates.”
Financial conditions by historical standards are currently considered loose, albeit becoming more stringent.
In fact, there are many moving parts, and policymakers’ biggest fear is that by controlling inflation, they won’t bring down the rest of the economy at the same time.
“They need a little luck here. If they get it, I think they can do it,” Zandi said. “If they do, inflation will moderate as supply-side issues subside and demand growth slows. If they can’t keep inflation expectations tethered, then no, we’re going to enter a stagflation scenario.” and they will have to shrink the economy into a recession.”
(It’s worth noting: Some at the Fed don’t think 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 is based on “extremely shaky foundations”).
People who were present during the last serious episode of stagflation, in the late 1970s and early 1980s, remember that shock well. Faced with runaway prices, then-Fed Chairman Paul Volcker spearheaded an effort to raise the fed funds rate to nearly 20%, plunging the economy into recession before taming the inflation beast.
Needless to say, Fed officials want to avoid a Volcker-like scenario. But after months of insisting that inflation was “transient”, a central bank late to the game is now forced to tighten up quickly.
“Whether or not what they’ve been up to is enough, we’ll find out in time,” Paul McCulley, a former chief economist at bond giant Pimco and now a senior fellow at Cornell, said in an interview with CNBC on Wednesday. “What they’re telling us is that if it’s not enough, we’ll do more, which implicitly acknowledges that downside risks to the economy will increase. But they’re having their Volcker moment.”
To be sure, the odds of a recession look low for now, even with the momentary inversion of the yield curve that often heralds recessions.
One of the most widespread beliefs is that employment, and specifically the demand for workers, is only very strong to cause a recession. There are about 5 million more job openings now than there are available labor, according to the Labor Department, reflecting one of the tightest job markets in history.
But this situation is contributing to the increase in wages, which in March increased by 5.6% compared to the previous year. Goldman Sachs economists say the job gap is a situation the Fed must address or risk persistent inflation. The firm said the Fed may need to cut gross domestic product growth to the 1%-1.5% annual range to slow the labor market, implying an even higher policy rate than markets are prices for. currency, and less room for maneuver for the economy. to lean toward at least a shallow recession.
So it’s a delicate balance for the Fed as it tries to use its monetary arsenal to drive down prices.
Joseph LaVorgna, chief economist for the Americas at Natixis, is concerned that a picture of faltering growth now could test the Fed’s resolve.
“Out of the recession, you’re not going to bring down inflation,” 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 tough now. But if you do a few more hikes and suddenly the employment picture shows weakness, is the Fed really going to keep talking tough?”
LaVorgna is looking at steady growth in prices that are not subject to business cycles and rise as fast as cyclical products. They may also not be subject to interest rate pressure and are rising for reasons unrelated to easy policy.
“If you think about inflation, you have to reduce demand,” he said. “Now we have a supply component. They can’t do anything about supply, so they may have to squeeze demand more than normal. That’s where the downturn occurs.”