With the latest Consumer Price Index (CPI) data indicating that inflation remains historically high, the Federal Reserve received exactly the signal it was looking for to continue to justify aggressive monetary tightening in the months coming. But his Volcker-inspired strategy of rapidly raising interest rates is far more likely to lead to stagflation, a slow-growing economy with high levels of unemployment and inflation, than to actually dampen inflation.
The reason the Federal Reserve is unlikely to get inflation under control this time around is that the main drivers of inflation today are rising food and housing prices, both of which are on the rise. supply crisis, none of which will be solved by raising interest rates.
For food, global conflicts and drought are driving up prices. India’s recently enacted restrictions on rice exports will only make matters worse in the short term, and Russia could cause another spike in grain and wheat prices at any moment if it tears up its grain deal. with Ukraine, as Russian President Vladimir Putin is now threatening. Climate change, international war, and global trade deals are all well beyond the reach of the Federal Reserve, so the idea that they can drive down food prices given its causes does not is not convincing, to say the least.
On the contrary, the Federal Reserve driving higher interest rates will make it more expensive for American farmers to take out new loans and harder for them to increase supply relative to demand. In other words, in its quest to fight inflation, the Federal Reserve could make it worse.
For housing, the argument for raising interest rates is that it makes it more expensive to finance the purchase of a home, which lowers demand, which can theoretically lower prices. aggregated. At first glance, this makes sense. After all, if fewer people can afford a home, then fewer people will buy homes, which should mean prices go down until they can become affordable again.
But we have to keep in mind that the current surge in housing prices is not demand driven. This is the result of a massive supply shortage. Lowering demand could help at the margin, but unless a lot more homes are built, upward price pressures will persist.
Furthermore, the above demand destruction route to reducing housing inflation ignores the fact that demand can only be so low because housing is a basic need. Those who can’t buy must rent, and rent inflation is at an all-time high.
Here too, with housing, we could even see that higher interest rates could have the opposite effect in that the cost of financing the construction of new homes will increase as interest rates rise in arrow. It would make it less financially attractive to build more homes, prolonging the problem longer than if we just got by until the market corrects itself.
Why then is the Federal Reserve considering going ahead with further rate hikes? The Federal Reserve has a mandate to fight inflation but only has monetary policy weapons. Essentially, when the only tool you have is a hammer, every problem feels like a nail. Rather than admit inflation is beyond its control, the Fed remains determined to make do with what it has and, in turn, will achieve the results one would expect when a hammer hits a screw.
Another reason the Federal Reserve is unlikely to admit that it cannot solve the inflation crisis is simple hubris. The institution was created to do two things, one of which is to keep inflation low and stable over time. Admitting he can’t do anything about a problem he’s been openly tasked with dealing with would undermine his very reason for existing.
Nicholas creel is an assistant professor of business law at Georgia College and State University.