Raising Interest Rates Is the Wrong Medicine for Today’s Inflation

By L. Randall Wray

The mainstream consensus is that slow economic growth is a supply-side problem while inflation is a demand-side problem. In the run-up to the COVID downturn, the media’s favorite economist, Larry Summers, warned of long-term secular stagnation. Pundits attributed this to a variety of supply-side factors, including slow growth of the labor force (due to aging of the population), slow productivity growth (absence of innovation), low saving rates (constraining the supply of loanable funds), and excessive government budget deficits (that divert savings to inefficient uses). Given slow growth on the supply side, austere fiscal and monetary policy should keep demand in check to prevent inflation. For the past half-century, the prevailing wisdom has been that government should enforce economic speed limits to keep inflation in check. When the global financial crisis brought on the worst recession since the Great Depression, President Obama’s miniscule relief package reflected that thinking—and recovery took a decade.

The economic disruptions brought on by COVID caused a much sharper downturn due to lockdowns and breaks in supply chains. This time the Congress and two successive Presidents responded with much larger relief packages. The first round of checks was used to pay overdue bills and to build up precautionary savings; the second round brought spending up close to pre-pandemic levels. Larry Summers soon began to warn of inflation due to excessive demand.

In truth, as Yeva Nersisyan and I have shown in several publications at the Levy Institute,[1] Inflation picked up steam after the relief programs had run their course. Like our high inflation periods of the 1970s, inflation now is driven by rising prices of energy, food, and shelter costs—with some anomalies such as used car prices (temporarily boosted because of a shortage of new cars). In addition, sectors with strong oligopoly pricing power are taking advantage of higher inflation to boost profit margins. While apologists within the economic profession deny this, leaders of the megacorps proudly report to shareholders that markups have never been higher.

Pundits warn of another wage-price spiral that will produce intransigent inflation, but the truth is that US wages did not keep pace with inflation in our previous high inflation periods and are not doing so now. In spite of claims that labor markets are tight, the truth is that real wages (taking account of inflation) are not rising across the board, although there have been some much-needed increases at the bottom.

Higher oil prices feed through quickly to food, shipping, and other transportation costs. There’s some evidence that energy prices are already moderating. The biggest portion of shelter costs is the imputed rent of home-owner-occupied housing.[2] This is a fabricated number that can be impacted by rising actual rents, but it is a poor proxy for actual costs faced by homeowners and as such tends to overstate the burden of inflation. Still, there are significant price pressures across an ever-changing range of consumer items due to supply disruptions, many of these linked either to long and complex supply chains or to difficulties in staffing workplaces. As long as COVID continues to lead to shutdowns in China and to barriers to labor force participation by America’s parents, we will continue to face supply side problems.

President Biden—like all the Presidents since Jimmy Carter—has proclaimed that inflation control is the Fed’s job. While the Fed has other tools at its disposal, its favorite tool is the overnight interest rate target. As the joke goes, if all you’ve got is a hammer, everything looks like a nail. Chairman Powell’s hero is Paul Volcker, who hammered the interest rate to above 20%. Volcker helped to bring on the stagflation that tanked Jimmy Carter’s presidency and secured the Neoliberal era that brought us decades of Larry Summers’ secular stagnation. Powell may very well be able to produce a repeat performance!

Raising rates is precisely the wrong medicine. The theory is that raising rates will reduce the incentive to borrow so that spending will gradually drop and reduce pressure on prices. The truth is that consumer spending is not very sensitive to interest rates It should be fairly obvious that consumers are not borrowing to fill their gas tanks or their grocery bags. Higher rates have cooled mortgage markets and will suck some income from households with floating rate mortgages. However, the US is facing a severe housing shortage—especially of multi-family units—that will be made worse by higher costs of financing construction. We also need investments in infrastructure—including, most importantly, investments in greening our economy—that will probably be postponed. And if it is true that we’ve entered a “new normal” period of lower labor market participation, we will need investments in labor-saving technologies. The answer to supply side constraints is to make these investments in the supply side—not to cripple aggregate demand.

Even if Larry Summers was correct in his argument that relief spending was too big, the fiscal stance has already tightened significantly. Not only did the spending end, but tax revenues have been booming Together, the drop of transfer spending, plus the increase of taxes, have pulled a couple of trillion dollars out of the economy. A recession was already the likely outcome–even before Powell started raising rates. Indeed, if one looks back at our recessions and Fed tightening, it becomes apparent that the Fed’s timing is always impeccable: it always raises rates after fiscal policy has turned the corner toward austerity. That is, the Fed always raises rates as we move into recession. The talk about engineering a soft landing is nonsense. The combination of fiscal and monetary policy tightening in the face of continuing significant supply-side problems means a hard landing is likely.

For many months, the Fed had adopted the correct policy: patience. The global health pandemic turned out to be much worse and longer lasting than most of us expected. Further, it revealed the vulnerability of global supply chains that Neoliberalism created and relied upon. What we really need is a fundamental reform of our economy. That is, of course, a longer-term project. For the near-term we need to halt the interest rate hikes and renew relief spending better targeted to those who need it most.

We then need to support more investment in low-income housing (to moderate rent hikes), more investment in alternative energy (to reduce dependence on volatile and planet-destroying oil), and tackle price-gouging by the megacorps that dominates most sectors of the economy. There is probably no magic bullet that will bring inflation back below 2%, but it will eventually moderate. Some inflation is acceptable if we can keep employment up, reduce poverty, and put the economy on an environmentally sustainable path.

Larry Randall Wray is Professor of Economics, Bard College, Senior Scholar at the Levy Economics Institute, and Member of the Board of NJFAN. His most recent book is A Great Leap Forward: Heterodox Economic Policy for the 21st Century (Academic Press, 2020).

[1] https://www.levyinstitute.org/publications/is-it-time-for-rate-hikes-the-fed-cannot-engineer-a-soft-landing-but-risks-stagflation-by-trying; and https://www.levyinstitute.org/publications/whats-causing-accelerating-inflation-pandemic-or-policy-response
[2] https://www.levyinstitute.org/publications/still-flying-blind-after-all-these-years-the-federal-reserves-continuing-experiments-with-unobservables

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