Jerome's Follies

The Fed’s policies are pushing us into an unnecessary recession

Inflation is both extremely simple while also being deceptively complex. Simply put, the price of a given product is the equilibrium point where supply meets demand. If demand goes up without an increase in supply, or if supply goes down without a decrease in demand, then the price will go up and wallah, you have inflation. Actually, there’s a more nuance to it, but basically that’s what inflation is. However, as straight forward as that is, it’s not terribly helpful in addressing what to do about it. The problem is there are nearly infinite combinations of factors that can affect both the supply of, and the demand for, a particular product. Then multiply that by the number of different types of products that are sold, which each have their own factors affecting supply and demand, and you have an overall picture of inflation that is nearly beyond the human capacity to comprehend.

Our Current Response to Inflation

I’m going to at least partially delve into some of the factors pushing inflation, but before I do, I want to look at our response to the current inflation. Looking at presidential approval polls it’s pretty clear that the American people aren’t very happy about Joe Biden’s response to inflation. However, this only goes to show how widespread misunderstanding of inflation and its causes are. America is a capitalist country with open markets. Because of this there is surprisingly little the President can do to either increase supply or decrease demand which are the keys to getting inflation under control.

In the supply/demand equation that sets product prices, it’s the demand side that the government typically has more control over. Supply tends to come from private industry so there’s a limit what the government can do to influence that. However, with demand the government can pump money into the economy which will tend to encourage economic activity, but risk driving up inflation. During a recession this is how the government usually tries to jump start economic growth. Conversely, when fighting inflation, the government can suck money out of the economy and decrease demand in the process.

The most obvious way the government can do this is through taxes. Cutting taxes to encourage economic activity during a recession is always popular. However, increasing taxes to take money out of the economy and reduce inflation is politically more difficult. That makes it all the more impressive that Democrats were able to pass the 15% minimum corporate tax and increased tax enforcement on high earners this year. Both of those actions will increase tax collections for the Federal Government and should help bring down inflation. In the short-term however, they won’t have much effect. They don’t begin until next year, so we’re not likely to see much effect until the second half of 2023.

Interest Rates

The more common way we see the government address inflation is through setting interest rates. They do this by setting the short-term rates that banks lend to each other and the rate the government lends to banks. These rates tend to drive interest rates throughout the economy. Lowering interest rates encourages lending which puts more money into the economy, while increasing rates discourages lending taking money out of the economy. During the pandemic the Federal Reserve kept the rates near zero to encourage economic activity to lessen the effects of the recession. However, the economy recovered much faster than anticipated and the Fed was slow to respond with higher rates which was one of the factors initiating the current inflation.

Manipulating interest rates can be effective, but overall, it’s a pretty weak tool. It doesn’t directly affect demand, rather overtime it tends to nudge it either up or down depending on the circumstances. It’s also important to keep in mind the Federal Reserve is an independent government agency and not under the direct control of the President. That’s by design to keep interest rates from becoming a political hot potato. That’s why the term of the Chairman of the Federal Reserve doesn’t line up with presidential elections and why it’s not uncommon for Presidents to renominate a chairman even if they were originally nominated by a president of the opposite party. That was the case with Jerome Powell who was originally nominated by President Trump and just renominated by Joe Biden earlier this year.

The Federal Reserve’s Mistakes

The first mistake Jerome Powell and the Federal Reserve made was being slow to recognize that inflation was becoming persistent and to raise interest rates in response. The second mistake is in how they’ve been raising the rates even after seeing continuing inflation. The first couple of increases last spring were tepid and left rates at a historically low level. They became a little more aggressive over the summer, but continued to take a very conservative approach to the increases. They did, however, begin promising continued increases until inflation is under control.

This is a fundamentally wrong-headed approach for two reasons. First, we know that increasing interest rates will eventually bring down inflation, but only slowly over time. Raising the rate too much will discourage economic activity, resulting in a recession. In continually raising interest rates, by the time they impact inflation the Fed will have gone too far and caused an unnecessary recession.

The incremental increases are also likely to have the opposite effect of what they’re intending in the short run. By making small increases in interest rates and promising future increases, instead of discouraging lending, it’s sending the message you’d better get your loans now before the rates go up even more. Eventually rates will be so high that it will decrease lending, but by then it will be too late to avoid a recession.

What the Fed Should Have Done

The Federal Reserve should have come out with a big one-time rate increase as soon as it recognized the problem with inflation. Bringing the rates back up to the normal historical range, while also announcing there would be no further increases for the next 4 to 6 months. The effect would be to encourage more careful borrowing without needing to rush into more loans before additional rate increases. It would also have left the rates low enough to not completely freeze the credit markets leading to a recession. The decision of where the Reserve should set interest rates is a difficult determination to make. However, the persistent incremental increases the Fed has engaged in is leading the economy into recession with only limited effect on inflation.

From March to September of this year the Federal Reserve Discount Rate increased from 0.25% to 2.5% through a series of 4 incremental increases. It went up an additional .75% in Oct and is likely to go up another .75% in the near future. A single large increase in March taking the rate to 2.5% would have had more impact while also making additional increases less necessary. It also would have muted the potential for a severe recession caused by continual rate increases with no end point in sight. Jerome Powell, and the Federal Reserve in general tends to act with caution and is reluctant to make bold moves. In normal times that’s probably a wise policy. But in the unprecedented economic situation caused by the pandemic, bold action is what we needed, and they showed themselves not up to the task.

Causes of the Current Inflation

To be clear, making one bold interest rate increase in the spring was never going to instantly fix the current inflation problem. That’s because over lending wasn’t the primary factor driving the inflation to begin with. The pandemic caused various factories around the world to close at different times. While that was happening, people could no longer spend money on travel and other leisure activities, so they tended to order more stuff off the internet. Classic increase in demand and decrease in supply.

The fact that different locations had outbreaks at different times prolonged the effects of the pandemic. Our ports were operating at near capacity before the pandemic and weren’t equipped to meet increased surge in demand even when products were available to import. Trump’s tax cuts left many corporations sitting on big piles of money and the indiscriminate stimulus checks under both Trump and Biden left many who never stopped working with extra cash to spend. Oil producers overcompensated for reduced demand for fuel during the pandemic leading to global shortages after the economy started to recover. The twin effects of wheat shortages caused by the war in Ukraine and egg shortages caused by bird flu resulted in food prices surging this year. Excessive lending didn’t cause any of this. Higher interest rates will eventually affect demand and lead to decreased inflation, but only gradually.

Some of the supply chain issues have already started to work themselves out over the last year. From March of 2021 to March 2022, we saw a consistent increase in inflation from 2.6% to 8.5%. Demand surged while coming out of the Pandemic without a corresponding increase in supply. However, since then inflation has held steady with the current rate at 8.2%. That’s despite the war in Ukraine and the egg shortage. Once inflation sets in, it typically only slowly goes away. Many admire President Reagan for ending inflation in the 1980s, even though it was Carter’s Fed Chairman who instituted the tough love polices that got it under control. People tend to forget that inflation was still at 5.4% a decade after Reagan’s election.

Conclusion: Moving Forward

At this point the best thing Jerome Powell can do for inflation, and the economy, is declare a freeze on further interest rate increases. Rates are already above the historical average which will slowly put downward pressure on demand. Supply chains will continue to sort themselves out and alternative sources of wheat will increase global supplies. Freezing further rate increases will also take away pressure to get loans right now before rates go up again.

There’s a lot of pressure on Powell to take action, but the boldest action he can take now is to announce he’s not going to make any further interest rate increases, at least in the short-term. Regardless of what the Federal Reserve, Congress or Biden do to fight inflation, it’s likely a year from now it’ll be lower than it is now, but higher than what we have come to expect over the last 20 or 30 years. Powell needs to ask himself, is it worth driving the economy into the ground for little if any benefit in lowering the rate of inflation? The commonsense answer to that is no, but like my Daddy always said, “sometimes common sense ain’t so common.”