The last time, I wrote about monetary policy here, I argued that financial markets expect too many rate hikes by the Fed. Well, that was wrong. In fact, the Fed has turned even more hawkish than markets had expected back then. In line with that, interest rate futures now indicate that the Fed’s target rate will be raised up to 4.50-4.75% in March. With the benefit of hindsight, it seems to be clear that the Fed, after having been blamed for underestimated the severity and persistence of inflation, did not want to get burned again. Instead, they decided to err on the side of hawkishness.
My fundamental concerns with this approach have not changed! To be sure, one of the central bank’s core mandates is to maintain or restore price stability. And when we face demand-pull inflation, i.e., higher prices due to strong demand and an overheating economy, there can be no doubt at all that interest rates should go up. But currently, the high inflation rates in the US and around the globe are simply not the result of strong demand, but are caused by various adverse supply shocks, notably high energy prices and ongoing supply chain disruptions. And I think we can all agree that neither higher interest rates nor quantitative tightening do anything to mend the situation. Fighting inflation caused by an adverse supply shock with tighter monetary policy may thus be like pushing on a string – in any case it will come at extremely high costs to the economy.
This thought can easily be explained by standard textbook economics (see chart): Pre-crisis, the economy’s equilibrium was point A, with real GDP at Y0 and overall prices at P0 (in a dynamic context, one can interpret GDP as economic growth and prices as inflation rates). As the result of an adverse supply shock, the aggregate supply curve shifts to the left, from AS0 to AS1. This causes a drop in GDP to Y1, and an increase in prices to P1 – the infamous stagflation (point B). Now add monetary tightening: When the central bank raises rates, this has an impact on aggregate demand – usually via lower investment spending, but we can also imagine a drag on private consumption. In any case, tighter monetary policy shifts the aggregate demand curve to the left, from AD0 to AD1. If demand is being reduced enough, the economy will eventually move to point C, where prices (or the inflation rate) are back to their pre-crisis level, P0. At the same time, however, real GDP has been reduced further from the already depressed stagflation level to Y2, indicating a significant hit to economic activity.
The argument, according to which higher inflation calls for higher interest rates, is in the current environment thus way too simplistic. Paul Donovan, Chief Economist of UBS Global Wealth Management, recently even asked “does hiking rates work?”. As “more and more of CPI is made up of prices that monetary policy has less and less influence over. The Fed is forced to create more disinflation and deflation in the areas where policy does have an influence.” This further corroborates my point that if monetary policy wants to successfully curb inflation, it has to significantly weaken the economy and ultimately the labor market. To put it differently: households and businesses, who are already suffering from high prices will further be burdened by higher interest rates and rising unemployment. Sounds like a plan.
One of the most interest rate sensitive sectors in every economy is the housing market. In the US, raising rates have already triggered a collapse in existing home sales, which plunged 6% in July alone and are down a whopping 20% yoy. And as monetary policy tightening typically affects the economy with long and variable lags, I dare to question the Fed’s decision to plow forward with aggressive rate hikes. Along the same lines, Nobel laureate Joe Stiglitz and the co-director of the CEPR, Dean Baker, recently argued that “with recent data showing that both inflation and inflation expectations have eased, it would be irresponsible for the US Federal Reserve to create much higher unemployment. Amid so much uncertainty, it should instead pause interest-rate hikes until a more reliable assessment of macroeconomic conditions is possible.”
But despite this sober assessment of the effectiveness of monetary policy, there is a silver lining!
- The NY Fed’s Global Supply Chain Pressure Index has declined by 66% from its peak in late 2021.
- Drewry’s composite World Container Index posted its 29th consecutive weekly decline in mid-September. While the index is still 34% above its 5-year average, it is now 52% below its peak reached last September.
- The Philly Fed prices paid index dropped from 85 points in April to 29.8 in August, which is only slightly above its five-decade average of 29.
- Various commodities, from oil to industrial metals to food have posted significant declines in recent months.
Importantly, as Stiglitz and Baker put it, “most of the main factors behind today’s inflation have little to do with curbing demand. Supply-side constraints drove inflation higher, and now supply-side factors are bringing inflation back down.” I concur. And with inflation expectations stable, there is no need for the Federal Reserve to tighten the economy into a recession.