To say that the Federal Reserve is between a rock and a hard place is an understatement.
Markets want a halt to inflation, but they don’t want a full-fledged recession or sustained drop in economic activity. Households and consumers want their dollars to stretch further and not be short-circuited by price increases in things they buy. And firms like low interest rates and worry about rising rates since they have become used to borrowing very cheaply over the past decade. The problem is that there is no miracle cure for inflation.
The Federal Reserve will undoubtedly increase rates again soon, after three rises since May, and they may not be done. Chairman Jerome Powell has said he will continue to fight inflation with tough monetary policy.
But let’s take a closer look at inflation. Starting with the notion that a good deal of current inflation in the United States is due to what economists call the “supply side,” namely increases in the prices of commodities like fuel, food and fertilizers as well as lingering issues caused by supply shortages during the pandemic, we cannot conclude that the economy is overheating.
Some have argued that the commodity spike will come down, just like gas prices have receded. And there is some preliminary evidence that shipping costs have come down and global supply chains may be returning to normalcy. Others, however, worry that inflation has become imbedded in expectations and will continue to thrive unless arrested.
The difficulty is that to contain inflation from the demand side, the only avenue open to policymakers, the Fed may have to dial the economy down so tightly that it causes recession. Currently low unemployment would rise, and people would be laid off, and the economy would tank. Whether this outcome is avoidable is the real question, and few have that answer.
Some might ask why prices are rising in areas unaffected by these supply shocks. Why should the price of toothpaste increase? Some observers would say it’s a result of firms anticipating inflation and wanting to get ahead of it. Others might say that many sectors in the U.S. economy are controlled by a few large firms that can afford to exercise their market power.
Past efforts at jawboning firms to hold the line on prices have all failed, and controls on prices are both undesirable as policy and impossible to implement and hence a non-starter.
Another consideration related to the Fed’s policy of raising rates is that it is engaged in “Quantitative Tightening,” a long-overdue action to soak up excess liquidity that was pumped into the financial system through a policy aptly known as “Quantitative Easing,” whereby the central bank bought all sorts of assets and added them to its balance sheet. This policy that began after the Great Recession and took on greater steam during the pandemic lost its rationale in 2021 and should have been phased out. The Fed has been justly criticized for its inaction; however, the result is that its balance sheet more than doubled over the last three years and now sits uncomfortably at $9 trillion.
As the Fed allows these purchased assets to mature and sells others, the effect is to reduce liquidity. Combined with rising rates, this is a double whammy for some firms. Specifically, it means firms that are highly leveraged (heavily indebted) will increasingly find it difficult to refinance themselves, resulting in more financial problems and more potential bankruptcies.
Wouldn’t it be ironic if the Fed’s actions did very little in the fight against inflation, but resulted in more corporate distress? This is reason to consider the Fed’s position as largely untenable. The most we can hope for is that supply-side constraints ease, corporations keep their price increases in check, and that labor markets continue to flourish. Inflation may well have peaked, and the right course of action for the remainder of 2022 may be to let it recede on its own.
Compounding past mistakes with new errors would be misguided, unfortunate and costly.