SOURCE: Let’s talk about today’s big news on the inflation front: what is the Fed trying to accomplish by raising interest rates, and what are the potential consequences?
The Fed has what is called a dual mandate. They are responsible for using their monetary authority powers to try to achieve maximum employment and price stability. Instead of being rigid or having absolute goals such as everyone working or no price change, these mandates tend to be interpreted by the Fed as avoiding excessive or damaging levels of unemployment or inflation.
So, while the Fed is aware that more people could be employed given the record number of job openings, the currently low national unemployment rate and still high inflation mean that the Fed is currently more focused on the second part of his term.
As for the consequences of Fed rate hikes, there are many channels through which these rate hikes affect what we sometimes call the “real” (or non-financial) economy. However, there are two classic ones that are mainly likely to have an impact on inflation.
The first is that higher interest rates make it more expensive for businesses, which use loans to finance their operations and are therefore interest rate sensitive, to maintain or expand their current operations and production. If many businesses simply maintain or even contract their operations, labor demand will also moderate and likely reduce household incomes and consumption, reducing pressure on prices.
The other, less indirect route through which rate hikes could reduce inflation is by increasing consumers’ borrowing costs for goods that are typically purchased on credit through mortgages, car loans, credit cards, etc. . This reduction in purchasing power would also reduce consumer demand.
Could this trigger a recession?
This will certainly lead to an economic downturn. Whether this turns into a recession remains to be seen.
What we’re hoping for is a soft landing. However, the Fed unfortunately has a relatively uneven track record in achieving such landings. This is partly because the US economy is a very large and complex system, and interest rates are a pretty crude policy tool by comparison.
Why is inflation so high in the first place?
The basic idea is that everything in economics is supply and demand. Right now we have more demand than usual for goods and services, and a lot of that is because people have more money than usual in their savings because they don’t have not spent so much money during the pandemic.
Now that the pandemic is less on people’s minds, people are going out again and they want to spend that money on things like vacations or better food, which is driving up demand.
It’s kind of an unfortunate coincidence that, at the same time as this is happening, we have a contraction in supply. Why is that? First, China, one of our major manufacturers, has an outbreak of COVID-19. Container ships are also incredibly expensive these days, and this is how the United States gets most of its imports from China.
The war in Ukraine is not trivial either. Russia is a huge supplier of fossil fuels, and because of the war and ensuing sanctions, gas prices are higher. The price of gasoline plays a role in everything, because if it costs more to transport a good to consumers, it makes that item more expensive in general.
Ukraine is also one of the largest suppliers of fertilizers in the world, which increases food prices.
Who is responsible for high inflation?
It’s easy to play the blame game. The president is really hammered on this, but it arguably has very little to do with inflation.
It does appear that large corporations are playing a significant role in driving inflation, given that they have been able to increase their profit margins in the face of other shocks that would normally explain sharp price increases. If companies just passed on the effects of supply shocks to prices on inputs, we wouldn’t expect to see margins widening.
The ability of companies to implement these margin-inflating price increases is in turn the result of long-term trends of increased industrial concentration in many industries. This is a phenomenon that predates the pandemic by decades and is the result of repeated policy decisions by the Justice Department under Democratic and Republican presidents not to fight increasing corporate market power. Essentially, their position was that increased concentration and reduced competition were acceptable as long as they did not lead to higher prices for consumers. It may be time for them to revisit this philosophy.
However, the institution directly responsible for fighting inflation is the Fed, which, as we have discussed, has just taken significant action. The results are yet to be seen.
When can we expect inflation to start stabilizing?
Colorado’s economy may have peaked – in the last report, inflation was down to 8.3% from 9.1%, the first drop we’ve seen in a year and a half . This is below the national average of 8.6%.
Colorado may have peaked, but it’s too early to tell. I am optimistic about a soft landing following the rise in interest rates, but I think it will take time.
It won’t happen next month, I can say that for sure. I like to believe that by the end of the year, we will see turning points in the economy.
Why is Colorado below the national average for inflation?
Colorado is actually on the low end because we have Suncor, an oil refinery in Commerce City, that produces 100,000 gallons of gasoline a day, and 95% of that goes to nearby Front Range.
This means that the state actually has our own little energy independence, so we are better off than other regions.
Additionally, the state has many oil wells that are a relatively short trip to the refinery, saving on transportation costs.
Your research focuses on the urban-rural divide. Is inflation worse in rural areas?
It has more impact. Part of the problem is transportation: In Colorado, all of the major distribution centers are on the Front Range, so it costs money to move supplies from Denver to other parts of the state.
Rising gasoline prices mean it is more expensive to get food to rural markets and to supply rural hospitals. In fact, everything is more expensive.
Additionally, rural residents tend not to have as many resources as urban residents. If inflation rises, basic necessities like food take up a larger share of a family’s budget. When staples like eggs double in price, it makes a real difference for less wealthy households.