Opinion: raising interest rates would do nothing to control inflation

As consumer prices rise at the fastest rate in nearly 40 years, the Federal Reserve is signaling that it will soon start raising interest rates. But the most important question has not even been asked: Would higher rates do something to suppress inflation?

It might be heresy for those who think the Fed is all-powerful, but the honest answer is that a hike in interest rates wouldn’t put out the fire. Unless millions of people were thrown out of work during a recession, higher rates would not rebalance supply and demand, a necessary condition for price stability.

The Fed (and those calling on the Fed to raise rates immediately) misdiagnosed the problem with the economy and demanded the wrong kind of drug.

The problem is not too much demand; it is too little supply.

Little borrowing

The rationale for a rate hike now appears to be that cheap credit has allowed spending to exceed the economy’s capacity to produce what people want to buy. As effective demand exceeds supply, prices rise rapidly. By raising short-term rates, the Fed hopes to slow the economy by making it more expensive for consumers and businesses to borrow money.

But does this story hold up right now? No.

Household debt is growing slowly despite very low interest rates.

Market surveillance

Over the past year, as inflation has soared, credit growth has been anemic despite very low interest rates TMUBMUSD10Y,
1.743%.
Real household debt has only increased by 2.2% at an annualized rate since the start of the pandemic while commercial loan is growing at the slowest rate in eight years, even after companies took on cheap pandemic loans in early 2020.

A rate hike would have little impact on the economy because credit growth is already weak.

easy credit doesn’t seem to be the problem. But something is driving up the prices, what could it be? Interest rates have been extremely low since 2009, but something has changed recently. I wonder what it can be? Maybe a global pandemic has something to do with it.

Lukewarm overheating

Larry Summers and other economists who want a Fed hike insist the economy is overheating. But what a strange overheating it is! In the third quarter, the economy had only grown at an annual rate of 0.8% since the pandemic began two years ago and key sectors are showing considerable relaxation, meaning the economy could turn much faster if the obstacles to growth were removed.

The job market is down 3.6 million jobs from pre-pandemic levels. The activity rate is down 1.5 percentage points, and not all of the people who dropped out are voluntary retirees. Over 12 million people are looking for a job or would like to work if they could. The capacity utilization rate for U.S. industry is 76.8%, down from the recent high of 79.9% in 2018.

These figures do not indicate that production is too high.

Income and expenses

The income does not overheat either.

Real personal disposable income has skyrocketed during the pandemic thanks to stimulus checks, tax and debt relief and unemployment benefits, but real per capita incomes are now just 1.9% higher than at the start of the pandemic.

Consumers may have a lot of savings aside, but their income does not increase very fast at the moment. Remember that most economies are at the top of the income scale, not the bottom of the scale, where people are struggling not only with rising prices, but also with unsafe working conditions. and uneven arrangements to ensure that their children and elderly parents are well taken care of.

Overall spending is not getting out of hand (it has grown 2.4% annualized since the start of the pandemic), but the pandemic has shifted spending towards some industries and away from others. Durable goods are in high demand (up 11% on an annualized basis), but the demand for services such as going to the movies (down 14%) or for travel abroad (down 52%) is growing. has dried up.

Opinion: Inflation is rife in the United States – here is where it is and is not

Stopping inflation means controlling the pandemic and helping the economy adjust to a new normal. To strengthen and shorten our supply chains for the inevitable next wave or the next pandemic, we need significant investments in new domestic and global supply capacities, including manufacturing and transportation. Most of all, it means attracting millions of potential workers who are turned off by lousy, dangerous and low-paying jobs.

Higher interest rates will not help us make these adjustments.

Lagging wages

In fact, while higher wages would help attract workers, the Fed is obsessed with its fear of the dreaded inflationary spiral of wage surges, in which workers who have tasted higher wages will insist on getting more each. year, forcing their bosses to comply with their demands and leave them no choice but to raise their own selling prices so that they can make the payroll.

No one who has never worked for a salary or paid them could ever believe such a ridiculous story. Businesses raise their prices when they can get away with it. Complete stop. Workers may already have had some bargaining power over wages, but their influence has been eroded. Even with big gains this year, weekly wages have lost about 2% of their purchasing power to inflation over the past year.

The Fed does not show such concerns about the inflationary threat posed by higher profits for businesses or higher asset prices for investors. Why? Because higher profits and stock prices are supposed to encourage more investment.

But this is another theory that has no basis in reality. The level of interest rates has almost no effect on the investment decisions of companies, which primarily look at the profit potential. The evidence is overwhelming that the ultra-low interest rates of the past decade have done nothing to encourage private investment.

Prices go up because essential inputs – labor, electronics, energy, transport – are scarce. Normally, the way to resolve this imbalance would be to encourage workers and companies to increase their supply. That’s the beauty of market economies: prices are continuous signals about the balance of supply and demand for particular goods and services. Higher prices encourage buyers to buy less and producers to produce more.

Markets cannot strike this balance on their own, so policymakers need to push and pull their levers to keep the economy on track.

Bad for the job

The Fed has been tasked with fixing this problem. Unfortunately, the Fed doesn’t have the tools to do this. Monetary policy works (in theory) by adjusting demand, but it has no direct impact on supply.

In addition, it has become evident over the past few decades that the Fed “has much less control over spending (and therefore inflation) than is generally believed,” as heterodox economists Dimitri B. put it. Papadimitriou and L. Randall Wray du Levy. Institute of Bard College said so in a recent policy document, “I still fly blind after all these years.”

Papadimitriou and Wray argue that the Fed gets a lot more credit for the great moderation in macroeconomics over the past 40 years than it deserves. The Fed, they say, wandered the wilderness for 40 years to no avail in search of a viable theory of inflation, ultimately settling on the misconception that inflation is caused by “expectations of inflation.” ‘inflation’. According to this idea, managing inflation is a simple matter of managing expectations (as measured by bond yields and surveys): if people (consumers, business leaders, workers and investors) don’t expect not at higher prices, then the prices will not increase.

Surveys of expected inflation did not predict the actual inflation that kicked off this year.

Market surveillance

The theory is inconsistent, unprovable, and probably turns causality upside down, say Papadimitriou and Wray. Expectations do not drive inflation, it is the other way around. The strongest evidence for this conclusion is that the current surge in inflation was not preceded by an increase in expectations. But once inflation started to rise, so did expectations.

And yet, the Fed still clings to this theory. The only rationale for raising interest rates now (since rate hikes cannot restore price stability by increasing the supply we need) is not to act decisively against inflation today. “Unanchors” inflation expectations. The tail really beats the dog.

Perhaps it is time to rethink the way we try to run the economy by shifting more responsibility for controlling inflation to fiscal and regulatory decision-makers, who can at least design their policies to meet the target.

Rex Nutting is a columnist for MarketWatch who has written about the economy and the Fed for 25 years.

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