The Inflation Game

It’s the Talk of the Town. Inflation is back.

The economy has gone from a recession (negative growth and low inflation ) in 2020 to high growth and higher inflation in 2021/2022.

Largely driven by the impact of COVID on the economy, the inflation we are experiencing today is a surprise. It didn’t creep up on us, or slowly start to rise.

This inflation is a rocket.

How do you grab a rocket out of the sky and bring it back to earth?

It isn’t easy and the Federal Reserve has the unenviable job of doing just that.

The Fed uses “monetary policy tools.”

One tool is to raise the Fed Funds rate, also called the overnight lending rate.

What is confusing is the relationship. How does raising interest rates lower inflation?

The answer is, there is no direct connection . This isn’t a Point A to Point B scenario.

Raising short term interest rates is about desired cause and effect.

The intended impact of higher interest rates is to slow the economy. When the economy slows, inflation comes back to earth.

Okay great but how soon? When will gas prices come down? When will food prices come down?”

Using the rocket analogy, The Fed will try for a soft landing which implies inflation coming down gradually. Raising rates just enough for a smooth reentry. 

If they raise rates too much, the rocket could have a “hard” landing. A hard landing means inflation has come down way to fast and the economy could be tipped into another recession.

The answer to “How Soon?” is, nobody knows.

What happens in the economy when interest rates go up?

Here is one example:

The impact of higher interest rates on the mortgage market has been swift. The cost of borrowing money to buy a house has gone from 3.70% to 5.70%. 

If you are looking to buy a home you probably have a specific amount you can afford monthly. 

Now, more of your budget will be used for interest payments, leaving less money for the principal amount, or cost of the home. Essentially you will have to look for a less expensive home. 

Or put buying a home on hold.

When people stop buying homes, home prices drop. 

That’s one whack at inflation.

What other ways can higher interest rates slow the economy?

The cost to borrow money increases for things other than homes, like autos or “big ticket” items like appliances.

Anything that must be financed through borrowing costs more. As a result, the demand for goods and services drops and prices come down.

The goal is to slow spending. When spending slows it means demand falls. When demand falls prices come down, reducing inflation.

On the plus side higher interest rates make saving more attractive. When people save more, they are by default not spending. Another way of reducing demand.

All these theories make perfect sense to Nobel Prize winning economists. Or the Chair of the Federal Reserve, or the Secretary of the Treasury.

But for the rest of us struggling with high gas prices, high food costs and high everything else, understanding the cause and effect of higher rates on inflation is a Rubik’s cube.

The real cause for concern is that by raising interest rates the economy slows TOO much. No one is spending. Everyone is saving. Oops. This is not the desired outcome.

Raising interest rates to tame inflation is not a perfect science. There is no way to know if raising rates is working, because it takes time to see the impact through all areas of the economy. We won’t know until “after the fact” if the medicine is working.

By the time the “data” is in, the economy may be veering off course. 

Ah, such is the life of monetary policy. 

Where did that rocket go?

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.