Hey Friends. I hope you are doing well today. This post will posit the idea that inflation may be different this time.
The Fed is trying to rein in inflation by increasing short-term interest rates. This is a tightening, or contracting, monetary policy that increases the cost of borrowing capital and thereby dampens demand for money. How does this help bring inflation under control, one might ask?
If money becomes more costly to borrow, less will be borrowed. If less money is borrowed, there will be less money to demand goods and services. If there’s less demand for goods and services, the cost of those goods and services will decline. Inflation is brought under control. That’s the thinking.
Of course, taming demand for goods and services will impact an economy, logically slowing it and produce recessionary pressures. The Fed is trying to walk a tightrope. That is, it is seeking to tame demand enough to bring red-hot inflation down to a level we’ve grown used to living with while not setting off a recession.
The efforts of the Fed largely work on the demand side of the “supply and demand” dynamic. If you bring down demand, in theory, prices should fall as the supply becomes more ample, relatively speaking, with fewer buyers.
However, we’ve all been reading about “supply constraints” ever since COVID came along. In almost all company earnings reports, a mention of “supply constraints” has become a norm. The Fed’s action to tighten or loosen interest rates no doubt will impact the demand for money, but how will its actions interact with the supply variable of supply and demand in the present environment of constrained supply? Does anyone today have a cogent answer for this?
I think it is the supply question that has the stock market aggressively buying one day, doing the opposite the next, and so on. That is, the market believes one day that the Fed can get inflation under control and the next it doubts it will. If a lack of supply becomes worse, then even if demand is reduced by raising the cost of money — will supply be ample enough to meet the reduced demand? If not, why would prices for goods and services decline significantly? Is it possible, prices for some goods and services could even continue to rise? If so, should the Fed even be raising rates if altering demand can’t do anything about the issue on the supply (output of goods and services) side? Could it be trying to control something by a traditional approach that can’t work in this setting? Could it actually exacerbate things by not getting a handle on inflation while at the same time risking setting off a recession?
You see, we may not be able to assume supply will be available to meet whatever demand level exists, an assumption we’ve made for years and one that has been largely true. This is a problem. The Fed could aggressively raise rates and it still might not stop hot inflation since the raising of rates isn’t addressing constrained supply problems “globally.”
My post is full of questions but lacking answers. These are interesting days. Wouldn’t you like to look behind the proverbial curtain and listen in on a Fed meeting over interest rates. I imagine the economists giving advice are as back and forth with their opinions from day to day as has been the recent movements of major stock market indices.
See you next time.
Interesting thought, Dr. Allen. Thanks for the questions.
An additional comment: I was listening to a program recently and the guest was asked why gold had not been performing well. His answer was that it was because of the type of inflation that is occurring. His thought was that there is inflation that results from a “debasement” of the currency and that which results for other reasons.
Thanks for commenting, Julian. The “other reasons” are leaving us all scratching our heads. In some ways, the Fed is trying to steer a wagon full of bottles of nitroglycerin across a bumpy canyon path to reach a desired destination intact. With regard to precious metals, I believe the “safe haven” aspect may become more pronounced. Cryptocurrency is about as far from a “tangible asset” alternative in terms of the safety aspect as one can get. The “safe haven” aspect may become the central driver of gold prices.
Perhaps the Fed can steer the wagon to safety. I hope so. But the challenge is notable. In the background is the national debt. When does it become a part of the daily conversation in light of rapidly rising interest rates?