Simultaneous Inflation and Recession

The Fed has been aggressively raising interest rates to contain inflation. Classic economic theory states that higher interest rates will slow the availability of debt and lower cash in circulation. This leads to less demand for goods and services, which will also reduce the demand pressure that is driving inflation. The critical word here is demand. If the driver of inflation is excess demand, a contraction in demand will result in a drop in the inflation rate. However, the interaction between supply and demand determines prices, and higher interest rates do not affect the supply side of the equation.

Current Inflation

The recent uptick in inflation coincided with the global recovery from COVID-19. Increased demand strained supply chains that had essentially shut down during the height of the pandemic. The result was shortages and higher prices for many goods. Most economists (including those at the Fed) expected supply chains to return to normal and bottlenecks to disappear. That is why the conventional wisdom was that inflation would be “transitory.”

Unfortunately, inflation did not subside. Prices continued to rise, and the outbreak of war in Ukraine quickly added fuel to the inflationary fire. We have seen months of price spikes, with U.S. inflation running over 8%.

Why the Fed’s Tools May Not Work

The Fed only controls monetary policy, so its response to inflation has been to increase interest rates, often referred to as a tightening policy. The intention is to slow the economy by raising the cost of money. Consumers and businesses will experience higher costs associated with borrowed money, including higher mortgage payments, car loans, credit cards, and business loans. The higher prices should slow demand, but they will not affect the supply of goods and services.

Energy and food are two of the main drivers of current inflation, but the Fed has no control over the supply of raw materials. They can’t force oil exporters to increase crude oil production, and they cannot increase food production. Demand for energy and food is inelastic, meaning consumers can’t stop driving to work or feeding their families because of higher prices. 

Some economists argue that raising interest rates can actually be inflationary for two reasons. Higher interest rates will dramatically increase the costs of servicing the U.S. national debt. And increased purchase power by U.S. demand may paradoxically increase the supply chain crunch. 

The interest rate on the 10 Year Treasury Note has skyrocketed from under 2% to over 4% in 2022, more than doubling the cost of money for the U.S. government. The meteoric rise of the dollar means that imports into the U.S. come at a deep discount due to the increased purchasing power of the dollar. Therefore, we may increase demand for foreign imports by raising interest rates to curb demand for goods.

Stagflation

Stagflation is a term that dates back to the 1970s. High budget deficits, low interest rates, oil embargos, and the collapse of managed currency rates were among the chief causes of stagflation at that time. Inflation persisted until Fed Chairman Paul Volcker took draconian measures, including raising interest rates above 19%. 

The U.S. experienced many severe recessions before containing inflation. Several of the same forces that drove inflation in the 70s are in play today. The hope is that it will not take an entire decade to get prices back on a stable trajectory, but no one knows if monetary policy alone will get the job done.  

Possible Courses of Action

There will no doubt be calls for fiscal policy initiatives to aid the Fed in reducing inflation. Congress could help by either cutting spending, raising taxes, or a combination of both. But they would need to come to a consensus to take the necessary action. Most analysts agree that implementing these policies will be challenging, given the current political environment.

The Fed may dampen inflation on its own. An end to the war in Ukraine would be a big help, causing a drop in global prices for food and energy. Consumers’ expectations also drive inflation, so Fed Chair Powell’s unequivocally hawkish stance may help set beliefs that prices will stabilize. Additionally, technology has been a driving force in increasing productivity and keeping prices low over the last two decades. Once again, technology may play a role in bringing costs down. 

To his credit, Fed Chair Powell has recognized that expectations are critical and has made multiple speeches stating that he will not stop raising rates until inflation stops. Unfortunately, this implies that the Fed will likely take interest rates to the point where the economy experiences a significant contraction. As he said in August 2022, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”