The Fed’s Battle Against Inflation

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The US Federal Reserve (or Fed for short) central bank has raised interest rates this year in an attempt to bring down inflation. Before addressing the economic consequences of this situation, a few words on central banks seem in order.

Ordinary retail and consumer banks do their own banking with central banks, making deposits and borrowing money. Central banks in turn regulate ordinary banks to ensure that they remain solvent. But their most important function is to change interest rates to control inflation and unemployment.

Central banks set the rate at which they lend money to banks and control the rate banks charge each other for loans. When inflation is high, central banks raise these rates. The banks then charge their customers more for the loans. When unemployment is high, central banks reduce the rates they charge banks. Banks then lower the rates they charge businesses and consumers. Higher interest rates reduce spending and aim to dampen inflationary pressures; lower rates increase spending, economic growth and employment.

Currently, the unemployment rate in the United States is below 4% and close to its lowest level in 50 years. Inflation, below 2% in BC’s (pre-Covid) years, topped 9% for the year ending June 2022, its highest rate in four decades. Last year, the Biden administration provided many benefits to American families (like stimulus checks and a refundable tax credit) through the US bailout, helping them keep up with rising prices (see my article in the March/April issue Washington Spectator). These programs are now expired. As prices rise much faster than incomes, Americans are struggling to pay rent or mortgages, fill up on gas and put food on the table.

The Fed responded by raising interest rates. From almost 0% in January, it raised interest rates by a total of 2.25 percentage points between March and July. And he expects to raise rates by another percentage point before the end of the year.

In retrospect, the Fed should have started raising rates last fall, when the US unemployment rate was below 5% and falling and government spending programs stimulated the economy. Focusing on keeping unemployment low, the Fed lagged behind the inflation curve. Now he’s looking to make up for lost time and deflect blame for keeping rates too low for too long.

Consumers are already feeling the consequences: higher mortgage rates, higher interest rates on auto and college loans, and higher rates on credit card balances. This is one of the disadvantages of reducing inflation.

Many economists worry that the Fed could push the United States into a recession, leading to the dreaded stagflation (high inflation and high unemployment at the same time) that plagued the economy in the late 1970s and early 1980s. Often the Fed went too far when it started raising rates. Fed Chairman Paul Volcker overdid it in the late 1970s and early 1980s, resulting in a 10% unemployment rate. In the early 1990s, Fed Chairman Alan Greenspan raised rates, creating a recession that helped end more than a decade of Republican rule in Washington. He raised rates again in 2004, which generated very slow economic growth and soon had to reverse.

Even if it is not won in advance, a recession is very likely. We may already be there. The US economy shrank 0.4% (1.6% annualized) in the first quarter of this year and 0.2% in the second quarter. Additionally, three recession indicators are flashing brightly: the stock market has fallen sharply this year; commodity prices (oil, cotton, copper, even corn and wheat) are falling; and the yield curve has inverted (interest rates on short-term government bonds are exceeding interest rates on longer-term bonds).

Another problem is that while higher interest rates can control the inflation caused by too much spending, the Fed cannot counter the supply problems we are currently facing. Interest rate hikes will not reduce high gasoline prices resulting from a Russian oil embargo. They will not replace the loss of Ukrainian grain on the world food market. They cannot reduce the high prices of automobiles and household appliances that stem from a shortage of computer chips due to a drought in Taiwan. And they can’t undo labor shortages resulting from Covid.

Worse still, higher interest rates can increase inflation. This is most evident in the case of housing, the main expenditure category for most households. Interest rates on a 30-year fixed mortgage rose from 2.8% last August to 5.5% in mid-July. For a $450,000 mortgage, this increases monthly housing costs by almost $750. Those excluded from home ownership will remain tenants, increasing demand for apartments and driving up rents.

While the Fed can’t solve our current inflation problem, it didn’t create it either. He did not invade Ukraine. It didn’t provide tax cuts for the wealthy during the Bush and Trump administrations or give Covid benefits to many people who didn’t really need them during the Trump and Biden administrations. And he did not sharply raise tariffs on imported goods, making them more expensive. President Trump did. The Fed simply waited too long to start raising rates.

Yet the Fed is responsible for cleaning up the inflation mess. But its tools are weak and ineffective when it comes to supply-side inflation, and raising rates much further will sharply increase unemployment. The main anti-inflationary alternatives are reducing public spending and increasing taxes. But politicians are loath to adopt such policies because it harms their constituents, the people they rely on for re-election. Thus, by default, the task of controlling inflation falls to central bankers who are shielded from such political pressures.

Our great danger right now is that the Fed will wait too long to stop raising rates, just as it waited too long to start raising rates. As economists like to say, there are long and variable lags between changes in interest rates and when those changes impact the economy. It’s time for the Fed to hit the pause button. But the inflation problem that squeezes so many low-income and middle-class households has yet to be addressed.

The good news is that there is another solution to the inflation problem. As the Fed steps back to consider the impact of what it has already done, fiscal policy must take the lead in fighting inflation. Unlike the Fed, President Biden and Congress have the tools to fight supply-side inflation without creating a recession. They must use them! Apart from reducing inflation, these policy measures will also reduce the pressure on the Fed to continually raise interest rates in an effort to keep inflation under control.

Here are some things the President and Congress can do.

The president can temporarily reduce import taxes and other trade restrictions, and temporarily suspend requirements that ships carrying goods between two US ports must be built in the United States and operated by Americans. These actions would reduce the cost of all imported goods. Congress and the President can increase legal immigration and the number of seasonal work visas to address labor shortages and raise income taxes on the wealthy to reduce demand-side inflationary pressures resulting Covid relief bills that provided benefits to households that didn’t need the money and are now spending their windfall. This latter policy is far better than asking the Fed to raise interest rates again, which would hurt indebted low-income and middle-class households and raise mortgage rates and housing costs that are a big part of the monthly expenses for those who are not wealthy.

Finally, the president and Congress can provide tax breaks to companies that allow their employees to work from home, and grants to state and local governments that reduce train and bus fares for consumers. This latest policy will encourage people to use public transport when traveling. Both policies, by reducing the time spent driving, will help lower the cost of gasoline.

Steven Pressman is Assistant Professor of Economics at the New School for Social Research, Emeritus Professor of Economics and Finance at Monmouth University, and author of Fifty Great Economists, 3rd Edition (Routledge, 2013).

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