Why the ‘cure’ for inflation may be worse than doing nothing

Last week, the Federal Reserve announced its second consecutive monthly interest rate hike of 0.75% to combat inflation. It’s the biggest such move since the early 1980s, when it intentionally contributed to a massive recession and crushed the American labor movement to fight price increases.

The day after the recent rate hike, the Commerce Department released gross domestic product figures for the second quarter of 2022. According to this initial estimate, the U.S. economy shrank 0.9% over that period, after contracting 1.6% in the first quarter. Two consecutive quarters of economic shrinkage is one traditional definition of a recession (though many economists argue that this economy has many unusual aspects that rule out a recession, at least for now).

It is now clear that the Fed is being far too aggressive with its rate hikes. The current spate of inflation (reaching an annual rate of 9.1% in June) is overwhelmingly being caused by factors outside the Fed’s control, and these blistering hikes may have already tipped the American economy into recession. But if it simply backs off, there is still a good chance that inflation will cool off of on its own.

It is now clear that the Fed is being far too aggressive with its rate hikes.

As this chart from The Washington Post detailed, the source of inflation has shifted considerably over the last year. At present, it is primarily coming from three main sources: energy, housing and groceries. The reason for rising costs in these areas aren’t ones that interest rates will likely affect.

First, the Covid-19 pandemic caused enormous disruptions to economic production throughout the world, which will take years to repair. Those disruptions are ongoing in the largest manufacturing nation on Earth, China, thanks to its strategy of suppressing the spread of the virus with strict lockdowns rather than mass vaccination.

Second, there is Russia’s invasion of Ukraine. The sanctions placed on Russia in retaliation, and its choice to punish Western Europe by cutting off supplies of natural gas, have drastically disrupted the global supply of energy and food. Russia is a large producer of oil and gas, and both countries are among the biggest grain exporters in the world. Rising fuel costs then cause knock-on price increases.

July 30, 202200:27

Incidentally, this is why inflation has been as bad or worse in the rest of the world, where most governments did not enact a big stimulus like the American Rescue Plan back in March 2021. The eurozone, for instance, saw inflation of 8.9% in July, thanks largely to skyrocketing energy prices.

Third, there is lingering damage from the Great Recession. As the folks at Employ America are continually pointing out, after 2008’s economic meltdown, inadequate stimulus prompted a decadelong economic stagnation. That caused a corresponding collapse in investment, especially in housing. When the economy came roaring back in 2021 thanks to the pandemic relief packages, the U.S. was a decade short of new homes. Meanwhile, U.S. businesses had gotten used to running their operations as lean as possible and were totally overwhelmed by demand.

It follows that there are two basic strategies of dealing with the inflation. Either we can create enough goods and services to satisfy demand, or we can impoverish the American people so they can’t afford them anymore. The latter strategy is explicitly what the Fed is doing. High interest rates make it more expensive for people to get home mortgages and for businesses to invest, which causes mass layoffs, and thus less spending and fewer price rises. And this doesn’t just happen in the U.S.: The developing world relies heavily on dollar credit, and sure enough throughout Latin America, Africa and Asia the Fed’s hikes are seen as likely biting hard into poor economies.

Make no mistake, this could “work” in terms of reining in prices, though it might take several years. When then-Fed Chair Paul Volcker strangled the economy in the 1980s, he did so while pronouncing that “the standard of living of the average American has to decline.” Eventually inflation did come down — but today, it would come at the cost of not only prolonged high unemployment, but also perpetuating the post-2008 investment drought that is at the root of half our current price problems in the first place.

Other businesses that invested in new capacity now risk being bankrupted by the costs of idle facilities or unsold inventory.

On the rent question, America is not even close to building enough homes to make up for the post-2008 collapse in construction — but now thanks to the Fed, home sales and new home starts are plummeting. As John Maynard Keynes biographer Zach Carter pointed out in a recent speech: “Ask yourself: If the goal is lower rent, should we a) build more houses, or b) indiscriminately fire a large number of people from their jobs? The latter is the serious contention of this newly revived austerity brigade.” Other businesses that invested in new capacity now risk being bankrupted by the costs of idle facilities or unsold inventory.

Luckily, there are reasons to think that the worst supply problems are already behind us. The prices of wheat, corn, aluminum, oil and most other commodities have already fallen considerably from their post-invasion peak. Ukraine and Russia have reached a United Nations-brokered agreement to allow shipments of grain to proceed. The U.S. labor market has clearly softened over the last couple months, and wages are not keeping up with inflation — unfortunate for workers, of course, but implying that there is no spiral of wage increases driving price increases. If the Fed simply stands pat for a few more months, there’s a good chance prices will calm down without any need for a recession, sparing both businesses and workers alike from undue hardship.