With the latest Consumer Price Index (CPI) data indicating that inflation remains historically elevated, the Federal Reserve got exactly the signal it was looking for to continue justifying a policy of aggressive monetary tightening in the coming months. But its Volcker-inspired strategy of rapidly raising interest rates is far more likely to result in stagflation, a slow growing economy with high levels of both unemployment and inflation, than it is to actually dampen inflation.
The reason the Federal Reserve is unlikely to get inflation under control this time is that the primary drivers of inflation today are rising food and housing costs, both of which are experiencing a supply crunch and neither of which will be fixed by increasing interest rates.
For food, global conflict and drought are pushing up prices. India’s recently enacted restrictions on rice exports will only make things worse in the near term, and Russia could at any moment cause another spike in grain and wheat prices should it tear up its Ukraine grain deal, as Russian President Vladimir Putin is now threatening. Climate change, international warfare and global trade agreements are all well beyond the scope of the Federal Reserve, so the notion that they can bring down food prices given its causes is unconvincing to say the least.
If anything, the Federal Reserve bringing about higher interest rates will make it more more expensive for American farmers to take out new loans and harder for them to increase supply relative to demand. In other words, in its quest to fight inflation, the Federal Reserve may make it much worse.
For housing, the argument in favor of increasing interest rates is that they make it more expensive to finance a home purchase, thereby lowering demand, which can theoretically cause prices in the aggregate to come down. At first blush, this makes sense. After all, if fewer people can afford a home, then fewer people will buy homes, which ought to mean prices go down until they can once again become affordable.
But we must keep in mind that the current price spike in housing isn’t demand driven. It’s a result of a massive supply shortage. Driving demand down might help at the margins, but unless a lot more housing is built, the upward price pressures will remain.
Further, the above demand destruction path to lower housing inflation ignores the fact that demand can only go so low, as housing is a basic need. Those who can’t buy must rent, and rental inflation is at all-time highs.
Here, too, with housing we could even see that higher interest rates could backfire in that the cost to finance new home building will go up as interest rates soar. This would make it less financially attractive to build more housing, drawing out the problem for longer than if we just muddled through until the market corrected itself.
Why then does the Federal Reserve plan to charge ahead with more rate hikes? The Federal reserve is mandated to combat inflation but has only monetary policy weapons at its disposal. Essentially, when the only tool you have is a hammer, every problem looks like a nail. Rather than admit that inflation is beyond its control, the Fed remains intent on swinging away with what it has and, in turn, will get the results you would expect when a hammer strikes a screw.
Another reason that the Federal Reserve is unlikely to admit it cannot solve the inflation crisis is simple hubris. The institution was created to do two things, one of which is to keep inflation at a low and steady rate over time. Admitting that it cannot do anything about an issue it was overtly tasked to take on would undermine its very reason for existing.
Nicholas Creel is an assistant professor of business law at Georgia College and State University.