On August 10, 2022

Fed’s solution to inflation

By Kevin Theissen

The Federal Reserve has been dealing with the worst inflation in over four decades. Investors, consumers, and workers are also feeling the sting of higher prices. High inflation has forced the Fed to react by turning up interest rates at the fastest pace since the early 1980s, according to St. Louis Federal Reserve data. As a result, higher rates have pressured stocks. Rising yields have also pressured bonds as the price of bonds moves in the opposite direction of yields.

We are all aware of the higher prices we are paying for a range of goods and services and government data shows that wages aren’t keeping pace with inflation. So why is the Fed raising interest rates to tackle inflation?

Inflation raged in the 1970s until Paul Volcker was appointed chairman of the Federal Reserve in 1979 and drove interest rates through the roof. In 1981, the Fed briefly pushed the fed funds rate over 20% where to that, the rate was near 10%. When rates soar to these high levels, economic activity grinds to a halt because of the soaring cost of money. The jobless rate jumped, production fell, and excess capacity in the economy rose. It’s the opposite of today’s supply chain problems. Simply, the supply of goods and services exceeded the demand for goods and services. Also, because businesses didn’t need as many workers, there was less pressure to bid up wages. This is again the opposite of today’s environment. As a result, costs came down, which removed the pressure to raise prices and with falling demand brought on by a steep recession, most businesses lost the ability to quickly raise prices. In the end, the rate of inflation came down. But it took a very painful recession to squeeze a vicious inflationary cycle out of the economy.

This isn’t the 1970s, but the concept is similar, raise interest rates, which raises the cost of money, which then slows demand. Slower demand would likely reduce the high job openings. Slower demand makes it more difficult to raise prices, which would bring down the rate of inflation.

Gross domestic product (GDP), which is the broadest measure of goods and services in the economy, fell in the first and second quarters (U.S. BEA), which is the definition of recession. If we’re in a recession, it’s one unusual recession. Job growth is strong, and quirks in how GDP is calculated are playing a role in the weak numbers. For example, consumer spending was up in Q1 and Q2. So perhaps, instead of a recession, today’s environment might be more like ‘stagflation,’ or stagnate economic growth and high inflation.

The current Fed chairman, Powell, recognizes that it may take a recession to help get inflation back to the Fed’s 2% target, or an incredible amount of luck to engineer an economic soft landing, for example, slower economic growth that brings inflation down without a significant rise in the jobless rate.

Kevin Theissen is the owner and financial advisor of HWC Financial in Ludlow.

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