Fighting Inflation On Multiple Fronts

The Federal Reserve has begun its interest-rate hikes as its gears up its resources to combat inflation. This will not be a smooth operation. The inflation dragon it is up against has multiple heads so understanding the root causes of the current inflationary environment is key to selecting the optimum tactics in the struggle.

Some economists believe that the large stimulus packages approved by Congress to ease the pandemic is the main cause of inflation. First came the $900 billion dollar relief measure in 2020. Then there was the $1.9 trillion package in March of 2021. These funds plus largely unused consumer savings pumped billions into the economy and led to a sudden increase in demand for goods and high spending.

Others pin the blame on escalating energy costs. Alternative sources could not meet the demand for fuel to support large growth in the economy putting pressure on fossil fuel prices. Lack of new production sources and refusal of energy producing countries and companies to increase output have also led to skyrocketing prices. Boycotts of Russian gas has put additional pressure on energy prices.

Still other pundits point to the labor shortage which has pushed up wage growth as central to the inflationary spiral. The large number of quits has forced employers into a bidding war for talent.

Another key factor has been the disruptions to supply chain. Shortages of material have created big demands for all kinds of consumer and industrial goods. Certainly wheat, a food necessity, has experienced large spikes in prices as a result of the war in Ukraine.

It is more than likely that all the above have created the “perfect inflation storm”. 

The rate climbed to 7.9% in February. The consumer price index is reaching inflationary highs not seen since the early 1980s. The question has become, how do we navigate through these treacherous waters without precipitating a recession?

How the Fed Should React

The Fed has now stepped in with more aggressive action. It has begun implementing a series of interest rate hikes with an increase in the benchmark federal-funds rate by a quarter of a percentage point and promise of more rate increases throughout 2022. The aim is to make borrowing more expensive and hopefully cool down the economy. The perennial dilemma, raising interest rates too high and too fast could tip the economy into a recession. Not raising them high enough might just keep the inflation winds blowing all that much longer, and perhaps stronger.

“Although it is anyone’s guess what will happen next with inflation, the data show that there is no reason to react rashly with large across-the-board interest-rate hikes,” cautioned Joseph E. Stiglitz, economist and Nobel Prize recipient.  “The economy is working through an unprecedented transition that could ultimately be a boon for workers; but only if policymakers let the process play out.”

Stiglitz worries that excessive interest rate hikes would be an overreaction that could stifle the emerging economic recovery from the pandemic.

A different view is held by another Nobel winner, Robert J. Shiller, professor at Yale. Shiller’s main concern is all the talk of a “wage-price spiral.” According to this economic theory, “Greedy businesses raise prices to increase profits, which causes greedy unions to demand higher wages which causes businesses to raise prices again and so on,” explains Shiller.  This damaging cycle can feed inflation expectations.

Shiller’s remedy. Let’s cool the rhetoric and let the professionals handle the inflation fight. “It’s the Federal Reserve’s mandate to keep inflation under control. It would be better if Americans refused to buy into these fears, calmed down and let the Fed do its job.” 

But Lawarence Summers, former Treasury Secretary and President of Harvard, believes the Federal Reserve has been late in moving against inflation. 

“I have been critical of the Fed for the better part of a year on its failure to recognize that inflation became, as of last spring, the most serious short-run threat facing the American economy,” noted Summers. 

He is glad the Fed “pivoted” and now is raising rates but he is skeptical that the rate hikes will be sufficient to curb inflation. “There is more risk in the Fed doing too little than doing too much.” In fact, according to Summers, “we are moving toward higher entrenched inflation.”

Virtually everyone is hoping for the so-called “soft landing.” That is, inflation rates drop but without the offsetting drop in economic growth that pushes the economy into a recession.

But it may be that the Fed moved too slowly in getting inflation under control. 

“We’re pretty far behind the curve,” said Eric Rosengren, former president of the Boston Federal Reserve. He contends that chances for a soft landing have declined. It’s clear that raising rates to cut inflation raises the prospect of recession.”

“If you’re raising rates rapidly, you don’t have time to see how the rate increases you’ve already done have slowed down the economy,” added Rosengren.