Here’s how raising interest rates from the Federal Reserve can help bring down inflation, and why it might fail

A customer shops at a grocery store on February 10, 2022 in Miami, Florida. The Labor Department announced that consumer prices jumped 7.5% last month compared to 12 months before, the largest year-over-year increase since February 1982.

Joe Riddell | Getty Images

Higher interest rates helping to stamp out inflation is essentially a faith doctrine, based on the old economic gospel of supply and demand.

But how does it really work? Will it succeed this time, when inflated prices seem, at least in part, beyond the reach of conventional monetary policy?

This dilemma is causing Wall Street confusion and market volatility.

In normal times, the Fed is seen as the cavalry pulling off high prices. But this time, the Federal Reserve will need some help.

“Can the Federal Reserve bring inflation down on its own? I think the answer is ‘no,’” said Jim Beard, chief investment officer at Planet Moran Financial Advisors. “They can certainly help rein in the demand side with higher interest rates. But it won’t offload container ships, it won’t reopen production capacity in China, and it won’t hire the long-distance truck drivers we need to get things done. Country.”

However, policy makers will try to slow the economy and curb inflation.

This approach is twofold: the Fed will raise benchmark short-term interest rates while also Reducing bonds by more than 8 trillion dollars They have built up over the years to help keep money flowing through the economy.

Under the Fed’s scheme, the transition from these measures to lower inflation goes as follows:

Higher rates make money more expensive and borrowing less attractive. This, in turn, is slowing demand to keep up with supply, which has been lagging badly during the pandemic. Decreased demand means that merchants will have to lower their prices to attract people to buy their products.

Possible effects include lower wages, a halt or even a decline in high home prices, and yes, a possible drop in ratings Stock market that has held up fairly well so far In the face of rising inflation and the repercussions of the war in Ukraine.

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“The Fed has been reasonably successful in convincing markets that its eye is on the ball, and long-term inflation expectations are in control,” Bird said. “As we look forward, this will continue to be the primary focus. It is something we are watching closely, to make sure that investors do not lose faith in the [the Fed’s] The ability to rein in long-term inflation.”

Consumer inflation soared At an annual rate of 7.9% in February It may have risen faster in March. Gasoline prices have jumped 38% over the 12-month period, food prices are up 7.9%, and shelter costs are up 4.7%, according to the Labor Department.

Predictions game

There is also a psychological factor in the equation: inflation is thought to be a self-fulfilling prophecy. When the public believes that the cost of living will be higher, they adjust their behavior accordingly. Firms boost their prices and workers demand better wages. It becomes a rinse and repeat cycle that can drive inflation higher than ever.

This is why Fed officials not only agreed to raise interest rates for the first time in more than three years, but they also They talked so hard about inflationin an attempt to reduce future expectations.

Recently, Fed Governor Lyle Brainard – Long-time supporter of low rates – delivered Tuesday speech Which stunned the markets when she said that policy needs to be tighter.

It is a combination of these approaches – concrete moves about interest rates, as well as “forward guidance” about where things are going – the Fed hopes to bring down inflation.

“They need to slow growth,” said Mark Zandi, chief economist at Moody’s Analytics. “If they take a little bit of power from the stock market and credit spreads widen and underwriting standards get tighter and housing price growth slows, all of those things are going to contribute to slower demand growth. That’s a key part of what they’re trying to do here, trying to make financial conditions a little tighter even Demand growth is slowing and moderating in the economy.”

Financial conditions by historical standards are currently loose, although tightening.

In fact, there are a lot of moving parts, and the biggest fear for policy makers is that in curbing inflation they are not causing the rest of the economy to slump at the same time.

“They need a little luck here,” Zandi said. “If they get it I think they’ll be able to make it.” “If they do, inflation will subside as supply side problems recede and demand growth slows. If they cannot keep inflation expectations captivated, then no, we will go into a stagflation scenario and they will need to drag the economy into recession.”

(Note: Some at the Fed don’t think the outlook matters The white paper was widely discussed A central bank economist in 2021 expressed doubt about the impact, saying the belief was based on “very shaky foundations”).

shadows of volker

Those who were present during the last serious bout of stagflation, in the late 1970s and early 1980s, remember the effect well. In the face of runaway rates, then-Fed Chairman Paul Volcker led an effort to raise the federal funds rate to nearly 20%, sending the economy into recession before taming the inflation monster.

Fed officials want to avoid a Volcker-like scenario. But after months of insisting that inflation was “temporary”, The party’s lagging central bank is now forced to tighten quickly.

“Whether or not enough has been planned, we will find out in due course,” Paul McCauley, a former chief economist at bond giant Pimco and now a senior fellow at Cornell, told CNBC in an interview on Wednesday. “What they’re telling us is that if it’s not enough we’ll do more, which is tacitly acknowledging that they’re going to increase downside risks to the economy. But they’re having their own Volcker moment.”

Certainly, the odds of a recession right now look low, even with the intraday yield curve inversion that often heralds downturns.

One of the most common beliefs is that employment, and specifically the demand for workers, is fair very strong now to generate stagnation. There are now about 5 million more jobs than there are available labor, according to the Department of Labor, reflecting one of the tightest job markets in history.

But this situation contributes to higher wages, which rose by 5.6% from a year ago in March. Economists at Goldman Sachs say the jobs gap is a case the Fed must address or risk persistent inflation. The bank said the Fed may need to cut GDP growth into the 1%-1.5% range to slow the labor market, which means a higher policy rate than currency rates in the markets – and less wiggle room for the economy to step in. At least shallow contraction.

“This is where you get the slack”

So it’s a delicate balancing act for the Fed as it tries to use its monetary arsenal to bring down rates.

Joseph LaVorgna, chief economist for the Americas at Natixis, is concerned that the now volatile growth picture could test the Fed’s resolve.

“Far from a recession, you’re not going to work to bring down inflation,” said LaVorgna, who was the chief economist at the National Economic Council under former President Donald Trump. “It’s very easy for the Fed to talk hard now. But if you go a few more times and suddenly the employment picture shows weakness, is the Fed going to keep talking hard?”

LaVorgna monitors the steady growth of noncyclical prices that are rising at the same pace as cyclical products. They may also not be subject to interest rate pressures and are rising for reasons unrelated to loose politics.

“If you think about inflation, you have to slow down demand,” he said. “Now we have the supply component. They can’t do anything about supply, and that may have to squeeze demand more than they normally would. That’s where the recession comes in.”

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