The Federal Reserve just raised interest rates for the fourth time this year. The 75 basis point, or 0.75%, hike means that the Federal Funds rate has risen by 300 basis point since March when the rate was near zero. Considering the inflation rate exceeds 8%, the Fed must get more aggressive.
The Fed’s shockingly irresponsible monetary policy in 2021 is the primary cause of today’s inflation. Starting in January 2021, the Consumer Price Index (CPI) started rising rapidly. Prior to the pandemic, the average monthly CPI increase was 0.1% or 0.2%. That meant annual inflation was in the 2% range.
In January 2021, the CPI increased by 0.3%, then, 0.4% in February, 0.6% in March and 0.8% in April. Clearly, inflationary pressures were building. Yet the Fed did nothing, dismissing inflation as temporary or transitory.
So, it continued to vastly increase the money supply by purchasing government securities $120 billion per month. It paid for this by simply (electronically) printing more money. At the same time, it also kept interest rates near zero.
This action increased demand in an economy that already had excess demand because the Federal government spent nearly $7 trillion more than was received in tax revenue for fiscal years 2020, 2021 and 2022.
It wasn’t until March of this year that the Fed finally ended its bond buying program and started to gradually raise interest rates. The March rate increase was only 25 basis points. By then the inflation rate exceeded 7%.
In June, the Fed finally realized that one of the goals of monetary policy — and its main charge — is price stability. Inflation was 8% and growing. That meant the Fed had to get serious about fighting inflation. It raised rates 50 basis points in May, 75 basis points in June, 75 basis points in July and another 75 basis points today, Sept. 21, 2022.
While inflation did pause in July and August of this year — mostly due to falling energy prices from decreased demand because there was no growth in the U.S., China and most other industrialized countries — the overall price level will inevitably increase again this fall. Worse, the U.S. and many other countries are starting to experience the dreaded wage/price spiral.
As inflation increases, organized labor seeks wage increases, not based on increased productivity but simply cause its workers feel they “need” higher wages to keep up with inflation. That means labor costs increase for business. Making matters worse, productivity has declined significantly in 2022, having fallen by 7.5% in the first quarter and another 2.5% in the second quarter.
That means labor costs will rise even more than the inflation rate. In order to maintain profitability, firms will have to raise their prices, leading to yet higher inflation. Then labor seeks even higher wage increases and the country gets locked into a wage/price spiral.
This must be stopped immediately. The only way to do that is for the Fed to get very aggressive with interest rates and raise those rates by at least another 1–1/2% to 2% before year-end. Failure to do so will lead to much higher inflation.
As is usually the case when an economist suggests this aggressive policy, other economists will cite new theories, saying things are different now and the Fed does not have to be as aggressive. They will also note oil prices are falling, supply chain disruptions are easing, and more adults are beginning to enter the labor market, all of which, theoretically, should reduce wage inflation.
While all of that is true, it is not enough to reduce inflation, mostly because energy prices will increase again in the fall, supply chain disruptions really did not significantly add to inflation and despite higher labor force participation rates, we still have a severe labor shortage.
And any new theories will be dispelled just like Modern Monetary Theory and Modern Supply Economics were shown to be incorrect.
The longer it takes the Fed to raise interest rates even higher, the more we will have an inflation problem.
In the 1970s the Fed did nothing to tame inflation, and inflation increased to double-digit levels by the end of the decade. Finally, the Fed acted aggressively in 1981 raising interest rates to double-digit levels.
Inflation did fall by the mid-1980s, but a very severe recession was experienced. In order to avoid that, the Federal Reserve Bank of the United States must take very aggressive action immediately.
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