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Here’s how the Fed raising interest rates can help get inflation lower, and why it could fail


On February 10, 2022, a customer shop at a Miami grocery store. According to the Labor Department, consumer prices rose 7.5% in February compared to 12 months ago. This is the largest year-over-year rise since February 1982.

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The belief that higher interest rates will help curb inflation is fundamentally a matter of faith. It’s based on the long-held economic gospel about supply and demand.

How does this work in practice? It will work, even though inflated prices appear to be beyond conventional monetary policy’s reach.

This is the reason Wall Street has become confused and volatile.

Normal times see the Federal Reserve as the cavalry that comes to the rescue of soaring inflation. The Fed will need help this time.

Can the Fed reduce inflation by itself? Jim Baird (chief investment officer, Plante Moran Financial Advisors), said that he believes the answer to this question is “no.” They can certainly help curb the demand side with higher interest rates. However, the government is not planning to empty container ships and reopen China’s manufacturing capacity. It also won’t be hiring long-haul truckers needed to transport goods around the country.

However, policymakers continue to attempt to subdue inflation while slowing down the economy.

This approach has two components: First, the Fed will increase short-term benchmark interest rates. Second, it will also raise long-term benchmark interest rates. reducing the more than $8 trillion in bondsIt has been built up over time to keep the money flowing throughout the economy.

The Fed blueprint explains that the process of transferring these actions to lower inflation is something like the following:

Higher interest rates mean that borrowing is more difficult and makes money more costly. In turn, this slows down demand in order to make up for the lackluster supply during the pandemic. Merchants will need to lower their prices in order to entice people to purchase their products.

There are potential impacts such as lower wages and drop in home prices. a stock market that has thus far held up fairly wellFaced with soaring inflation, and the consequences of the war in Ukraine.

Baird stated that “The Fed has been fairly successful in convincing the markets they are on top of things, and long-term inflation expectations remain under control.” As we continue looking forward, this will remain our main focus. We’re monitoring it closely to ensure that investors have faith. [the Fed’s]Capacity to control long-term inflation.”

Consumer inflation rose at a 7.9% annual pace in FebruaryThe pace of inflation was likely to have accelerated in March. According to Labor Department, gasoline prices rose 38% over the 12 month period. Food costs increased 7.9%, and shelter costs went up 4.7%.

Expectations game

Another factor is psychological: The inflation mythology can also be viewed as self-fulfilling. If the public believes that living costs will rise, then they change their behavior. The prices businesses charge are higher and the wages workers receive is lower. Inflation can be driven higher by this cycle.

Fed officials have not only approved the first rate increase in over three years but also have talked tough on inflationTo dampen future hopes,

Fed Governor most recently Lael Brainard — long a proponent of lower rates — delivered a speech TuesdayThe statement that the policy should be much tighter stunned markets.

It’s a combination of these approaches — tangible moves on policy rates, plus “forward guidance” on where things are headed — that the Fed hopes will bring down inflation.

Mark Zandi (chief economist, Moody’s Analytics) stated that slowing growth is necessary. They need to take some steam out of equity markets and reduce credit spreads and tighten underwriting standards. This will lead to slower growth of demand. They’re trying hard to improve financial conditions so that demand growth is slowing and the economy moderates.

Financial conditions based upon historical standards are still considered as being in good shape, although they may be getting more restrictive.

It is true that there are many moving parts. The biggest worry for policymakers is not to bring down the entire economy while they reduce inflation.

You need to have a bit of luck. Zandi stated that if they do get it, I believe they will be able pull it off. If they succeed, then inflation will slow down as demand grows slower and supply-side issues recede. If they are unable to maintain inflation expectations at a reasonable level, they will be forced to take the economy into recession.

It is worth noting that some Fed officials don’t think expectations are important. This widely discussed white paperOne of the central banks’ own economists expressed doubts about its impact in 2021, stating that the belief is based on “extremely weak foundations.”

Shades Of Volcker

The impact of the last severe bout of stagflation (in the 1970s and 1980s) is well-remembered by those who were there. Paul Volcker was faced with spiralling prices and spearheaded efforts to raise the Fed Funds Rate to almost 20%. The effort plunged the economy into a recession, before it could be controlled.

Fed officials are determined to prevent a Volcker-like situation. After months of insisting that inflation was “transitory,”The late-to-the party central bank has to now tighten their belts.

Paul McCulley (ex-chief economist of bond giant Pimco) said Wednesday that “Whether or not they have enough” and was a senior fellow at Cornell. What they are saying is that, if this is not sufficient, they will do more. Which implicitly recognizes that there will be downside risks to the economy. However, they’re having their Volcker moment.

Receding odds are low for the time being, even though there is a momentary yield curve Inversion, which often predicts downturns.

A common belief that is held by many is that there is no job, or a shortage of workers. too strong nowIt is possible to cause a recession. The Labor Department estimates that there are 5 million more jobs than labor available, which is a reflection of one the most tight job markets ever recorded.

However, this situation contributes to rising wages which are up 5.6% compared with a year ago. Goldman Sachs economists agree that the Fed has to fix the unemployment problem or there will be inflation. The bank said the Fed may need to take GDP growth down to the 1%-1.5% range to slow the jobs market, which implies an even higher policy rate than the markets are currency pricing — and less wiggle room for the economy to tip into at least a shallow downturn.

“That’s how you get recession”

It’s an important balance that the Fed must strike when it attempts to lower prices using its monetary tools.

Joseph LaVorgna is the chief economist for Americas at Natixis. He fears that the Fed could be shaken by a weakening economy.

LaVorgna said that inflation will not fall if there is no recession. He was also the Chief Economist for the National Economic Council. The Fed can talk hard now. However, if there are more hikes than necessary and suddenly the employment picture is weakening, does the Fed really intend to continue talking tough?

LaVorgna observes the steady rise in prices, which aren’t subject to economic cycles. These prices are also rising as rapidly as cyclical items. They may not be under the same pressure as interest rates, and they are increasing for reasons that have nothing to do with looser policy.

He said, “If inflation is a concern, then you need to reduce demand.” Now we have a supply component. They are unable to control supply. In this case, they will have to increase demand. This is where recession occurs.