AUSTIN, Texas (Project Syndicate)—Federal Reserve Chair Jerome Powell has now committed to putting monetary policy on a course of rising interest rates, which could boost the short-term rate (on federal funds
and Treasury bills
) by at least 200 basis points by the end of 2024.
“Whenever there is a structural change like an increase in energy costs or a reshoring of parts of the supply chain, “inflation” is inevitable and necessary.”
The stated reason for tightening monetary policy is to “fight inflation.” But interest-rate hikes will do nothing to counteract inflation in the short run and will work against price increases in the long run only by bringing on yet another economic crash.
Behind the policy is a mysterious theory linking interest rates to the money supply, and the money supply to the price level. This “monetarist” theory goes unstated these days for good reason: it was largely abandoned 40 years ago after it contributed to a financial debacle.
In the late 1970s, monetarists promised that if the Fed would focus only on controlling the supply of money, inflation could be tamed without increasing unemployment. In 1981, Fed Chair Paul Volcker gave it a try. Short-term interest rates soared to 20%, unemployment reached 10%, and Latin America spiraled into a debt crisis that nearly took down all the large New York banks. By the end of 1982, the Fed had backed off.
Since then, there has been almost no inflation to fight, owing to low global commodity prices and the rise of China. But the Fed has periodically shadowboxed with “inflation expectations”—raising rates over time to “pre-empt” the invisible demons, and then congratulating itself when none appeared.
The shadowboxing also ends badly. Once borrowers know that rates are going up over time, they tend to load up on cheap debt, fueling speculative booms in real assets (like land) and fake assets (like 1990s internet startups, 2000s subprime mortgages, and now cryptocurrencies).
Meanwhile, long-term interest rates
remain unmoved, so the yield curve flattens or even becomes inverted, eventually causing credit markets and the economy to fail. We now will likely see this feedback loop once again.
This time is different
Of course, this time is different in one respect. For the first time in more than 40 years, prices are rising. This new phase was kicked off a year ago by a surge in world oil prices
followed by rising used-car prices as the semiconductor supply chain snarled automobile production. Now, we are also seeing rising land prices (among other things), which feeds into (somewhat artificial) estimates of housing costs.
Inflation rates are reported on a 12-month basis, so once any shock hits, it is guaranteed to generate headlines about “inflation” for 11 more months—a boon for the inflation hawks. But since oil prices
in December were about the same as they were in July, the initial shock will be out of the data in a few months and the inflation reports will change.
True, the effect of more expensive energy will continue to percolate through the system. That’s unavoidable. Whenever there is a structural change like an increase in energy costs or a reshoring of parts of the supply chain, “inflation” is inevitable and necessary. To hold average price increases to the previous target, some other prices would have to fall, and that generally doesn’t happen.
The economy always adjusts through an increase in average prices, and this process must continue until the adjustment is finished.
What else can the Fed influence?
By reacting now, the Fed is saying that it would like (if it could) to force down some prices in order to offset rising energy and supply-chain costs, thereby pushing the average inflation rate back down to its 2% target as quickly as possible. Assuming the Fed understands that this is what it is doing, what prices does it have in mind? Wages, of course. What else is there?
Powell himself declared that the United States has a “tremendously strong labor market.” Citing the ratio of job openings against “quits,” he thinks there are too few workers chasing too many jobs. But why would that be? Considering that the economy is still several million jobs below the actual employment levels of late 2019, it seems that many workers are refusing to go back to crummy jobs at lousy pay. As long as they have some reserves and can hold out for better terms, they will.
As wages rise to bring back workers, and because most jobs nowadays are in services, higher-income people (who buy more services) will have to pay more to lower-income people (who provide them).
This is the essence of “inflation” in a services economy. Energy and most goods prices are set world-wide, so service wages are the only part of the price structure that the Fed’s new policy can affect directly. And the only way the policy can work—eventually—is by making working Americans desperate.
The takeaway for American workers: The Fed is not your friend. Nor is any politician who declares—as President Joe Biden did this month—that “inflation is the Fed’s job.” And I write that as a Democrat.
James K. Galbraith, professor of government and chair in Government/Business Relations at the University of Texas at Austin, is a former staff economist for the House Banking Committee and a former executive director of the Joint Economic Committee of Congress. From 1993-97, he served as chief technical adviser for macroeconomic reform to China’s State Planning Commission. He is the author of “Inequality: What Everyone Needs to Know” (Oxford University Press, 2016) and “Welcome to the Poisoned Chalice: The Destruction of Greece and the Future of Europe” (Yale University Press, 2016).
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