Here’s how the Fed raising interest rates can help get inflation lower, and why it could fail

On February 10, 2022, a customer shop at a Miami grocery store. According to the Labor Department, consumer prices rose 7.5% in February compared to 12 months ago. This is the largest year-over-year rise since February 1982.
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It is an assumption that rising interest rates can reduce inflation. This belief stems from the economic gospel of supply-demand.

It is not clear how it works. Will it be possible this time, with inflated prices that seem to exceed the capabilities of conventional monetary policies?

This is the reason Wall Street has become confused and volatile.

Normal times see the Federal Reserve as the cavalry that comes to the rescue of soaring inflation. This time though, the central bank will need help.

Can the Fed reduce inflation by itself? Jim Baird is chief investment officer of Plante Moran Financial Advisors. “I think that the answer is no.” They can certainly help curb the demand side with higher interest rates. However, the government is not planning to empty container ships and reopen China’s manufacturing capacity. It also won’t be hiring long-haul truckers needed to transport goods around the country.

Despite this, policymakers will continue to work to reduce inflation and slow down the economy.

Two-pronged approach: the central bank will increase benchmark short-term rates and simultaneously reducing the more than $8 trillion in bondsThis money has been accumulated over many years and helps keep money moving through the economy.

According to the Fed blueprint, lower inflation can be transmitted by these actions.

Higher rates can make borrowing more expensive and money less attractive. The lower rates cause a slower demand, which in turn makes supply less competitive. This has been a problem since the start of the pandemic. Merchants will feel pressured to lower prices in order to attract people to their products if there is less demand.

There are potential effects such as lower wages and a stop or even drop in home prices. a stock market that has thus far held up fairly wellFaced with soaring inflation, and the aftermath of the conflict in Ukraine.

Baird stated that “The Fed has been fairly successful in convincing the markets they are on top of things, and long-term inflation expectations remain under control.” As we continue looking forward, this will remain our main focus. This is something we are closely monitoring to make sure investors do not lose heart. [the central bank’s]Capacity to control long-term inflation.

Consumer inflation rose at a 7.9% annual pace in FebruaryProbably grew at a faster rate in March. According to Labor Department, gasoline prices rose 38% over the 12 month period. Food costs increased 7.9%, and shelter costs went up 4.7%.

It’s all about expectations

Another factor is psychological: The inflation mythology can also be viewed as self-fulfilling. If the public believes that living costs will rise, then they change their behavior. The prices businesses charge are higher and the wages workers receive is better. This cycle of “repeat and repeat” can lead to inflation rising even further.

Fed officials have not only approved the first rate increase in over three years but also have talked tough on inflationIn an attempt to reduce future expectations,

Fed Governor is in this vein Lael Brainard — long a proponent of lower rates — delivered a speech TuesdayThe statement that the policy should be much tighter stunned the market.

It’s a combination of these approaches — tangible moves on policy rates, plus “forward guidance” on where things are headed — that the Fed hopes will bring down inflation.

Mark Zandi chief economist of Moody’s Analytics said, “They need to slow down growth.” They need to take some steam out of equity markets and make credit spreads wider and ensure that underwriting standards are tightened and prices rise slowly, which will all contribute to slower demand growth. They’re trying hard to improve financial conditions so that demand growth is slowing and the economy moderates.

Current financial conditions are considered to be good, but becoming tighter based on historical standards.

There are many moving parts. Policymakers have the greatest fear that by lowering inflation, they won’t also bring down the rest of society.

You need to have a bit of luck. Zandi stated that if they do get it, I believe they will be able pull it off. They will see a moderated inflation rate as the supply-side problems recede and demand growth slows. If they are unable to maintain inflation expectations at a reasonable level, they will be forced to take the economy into recession.

This is important to note: The Fed doesn’t consider expectations as relevant. This widely discussed white paperIn 2021, one of the central bank’s economists expressed doubts over the effect and said that it rests on “extremely unstable foundations.”

Shades of Volcker

The impact of the last severe bouts of stagflation in the 1980s and 1990s is well-remembered by those who were there. Paul Volcker, the then-Fed Chair, led an effort to increase the Fed funds rate by nearly 20%. This plunged the economy into recession and caused the inflation monster to be tamed.

Fed officials desire to avoid anything like Volcker, as it should be obvious. However, after many months of insisting that inflation was “transitory,”A late-to the-party central bank must tighten its belts quickly.

Paul McCulley, a former chief economist for bond giant Pimco, and now senior fellow at Cornell said that it was up to us to determine if what they’ve planned is adequate. What they are saying is that, if this is not sufficient, we will do even more. Which implicitly recognizes that there will be downside risks to the economy. They are still having their Volcker moment.”

Even with the inversion of the yield curve that sometimes predicts recessions, it is clear that there are low odds of a recession.

A common belief that is held by many is that there is no job, or a shortage of workers. too strongTo create a recession. The Labor Department estimates that there are 5 million more job opportunities than labor available, which is indicative of one the tightest employment markets in human history.

However, this situation contributes to surging wages. They were 5.6% higher in March than a year earlier. Goldman Sachs economists believe that the Fed should address the situation to avoid persistent inflation. The firm said the Fed may need to take gross domestic product growth down to the 1%-1.5% annual range to slow the jobs market, which implies an even higher policy rate than the markets are currency pricing — and less wiggle room for the economy to tip into at least a shallow downturn.

“That’s how you get recession”

The Fed is trying to balance its monetary power to reduce prices, so it must be careful.

Joseph LaVorgna is the chief economist for Americas at Natixis. He fears that the Fed could be shaken by a weakening economy.

LaVorgna said that inflation will not fall if there is no recession. He was also the Chief Economist at the National Economic Council under Donald Trump. The Fed can talk hard now. If there are a few more increases and the employment picture starts to show weakness, will the Fed keep speaking tough?

LaVorgna has been watching steady price growth that is not affected by economic cycles. They are increasing just as fast as those for cyclical goods. These prices may also not be subject to interest rate pressure and could rise for other reasons than loose policies.

He stated, “If you consider inflation, you must slow down demand.” Now we have a supply component. They can’t do anything about supply, that’s why they may have to compress demand more than they normally would. This is where recession occurs.

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