The Federal Reserve has now increased interest rates by 4.25 percent since March of 2022 after holding them well below 2 percent for much of the time since 2008. It has been a series of moves designed to quell inflation — but was this the right policy path for the Fed?
Opinion On The Fed Hiking Interest Rates
Opinion is profoundly divided. The editorial board of the Wall Street Journal has pronounced it necessary, and that inflation has come from “the mistakes of easy money and fiscal profligacy that brought us to this unhappy pass.”
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Yet now some commentators feel that, since their impact takes time, we need to pause these increases. Peter Orzag at the Financial Times has warned of the dangers of over-tightening and suggested that sometimes the best course of action is to wait and see.
A few even hold that the increases were not needed, will do more damage than anticipated, and that interest rates will soon enough need to be reduced again to mitigate this damage.
Few economic theories are as widely accepted as this easy-money-and-fiscal-profligacy-cause-inflation theory, and its adherents have seized on our current bout of inflation as further proof. But since that theory’s heyday in the 1970s and ’80s, we have 40 years of evidence indicating that it is incorrect — 2022 aside.
So what is the evidence that easy money and fiscal profligacy cause inflation? We’ll define “easy money” as rapid growth in the money supply, and “fiscal profligacy” as large central government deficits — two things that are often conflated but are truly distinct phenomena.
Since World War II, the two primary pieces of U.S. evidence are the high inflation that lasted from 1973 to 1982, and the comparatively more moderate inflation of 2022. But the inflation of the 1970s was primarily due to an eventual ten-fold increase in the price of oil.
Oil prices came down only after domestic price caps were removed, spurring a boom in oil production that saw the number of oil and gas drilling rigs rise from 1,496 in 1977 to 4,521 in 1982, bringing a North American oil production jump from 12.2 million barrels a day to an extraordinary 15.4 million barrels a day. Predictably, by 1986, that surge in production brought the oil price per barrel down to $12 and sent inflation tumbling to 2 percent.
At the very moment that high inflation disappeared in 1986, money supply growth was at its highest point and government deficits were skyrocketing. In contrast, high inflation had raged in the 1970s at time when money supply growth to GDP was negative.
So much for the easy money/fiscal profligacy theory.
Evidence Against Fiscal Profligacy Theory
Let’s look now at the evidence against that theory. In the 40 years before COVID, the money supply mushroomed from 55 percent to 72 percent of GDP, and federal government debt vaulted from 31 percent to 109 percent of GDP. Yet inflation hovered near 2 percent.
In fact, looking at the 47 largest countries in the world since WWII, we find that there have been 30 instances where money supply doubled in five years or less, and only seven were followed by inflation. Further, we find that high inflation is often not preceded by high money supply growth. A similar pattern holds for high government debt growth.
For all the rampant government spending to combat the economic impact of COVID, it only brought the economy back to the total spending level that it would have reached for 2022 if COVID had never occurred.
As for the $4 trillion increase in the money supply brought by the Fed’s massive “quantitative easing,” that was brought by the Fed’s purchase of Treasuries and mortgage bonds from banks and other institutions. Those institutions simply used the proceeds to buy a different type of security — not to increase their lending or spending.
What then did cause the COVID era inflation we now see? First, COVID reduced the supply of goods as workers weren’t on the manufacturing line during the lock down, decimating the supply chain.
This is measured by the Fed in its Global Supply Chain Pressure Index, which jumped from 0.09 standard deviations in December 2021 to 4.3 standard deviations in mid 2022. That took inflation from around 2 percent to above 5 percent in 2021.
Then came an even bigger factor — the Ukraine War. Russia and Ukraine together are among the chief suppliers of three of the commodities most in demand around the world, namely oil, wheat, and iron. War caused the prices of those to jump markedly, and with that inflation rose from 5 to almost 9 percent.
Rising Inflation
Wages are less than half of the cause of rising inflation, so while they’ve contributed to the problem, their impact has been less than suggested. Some have said that an aging workforce means a diminished workforce, which they claim will take us to a new era of ongoing upward pressure on inflation. But, in Japan the aging workforce problem has been true for a generation and yet Japan has had among the world’s lowest inflation.
Inflation has now fallen below 8 percent. Will it continue to improve? As supply chains improve inflation will abate. The bigger and much-less-easily solved issue is the Ukraine War, which may well be morphing into yet another forever war. So, until the war ends or the world figures out how to obtain more oil, wheat, and iron from other sources, it will be much harder to get all the way back to pre-COVID levels.
So, is the 4.25 percent increase in fed rates helping to reduce inflation? The answer is an unfortunate yes. That increase has been a gut punch to the economy, which will certainly help bring down prices, but with damage. The more fundamental question is were those increases necessary, and the answer is no. Fix the supply chains and end the war and inflation will disappear on its own.
We should heed Mr. Orzag’s advice and wait to see the impact of rate increases that have already been made. We’re likely to see a notable slowdown in growth and a shift to the reduction of interest rates soon enough.
