The Fed has raised interest rates by 75 basis points for the second month in a row, taking the target range to 2.25-2.5%. Faced with the highest inflation in more than four decades, this is the Fed's most aggressive monetary tightening since 1981, with the first 75 basis points rise being the first since 1994.
In his remarks, the Fed Chairman Jerome Powell hinted at the need for a period of slower growth and weaker jobs market to bring down high inflation.
This belief draws its theoretical basis mainly from one of the most important and contentious concepts in Economics, the Philips Curve which emerged in the 1950s. It describes the inverse relationship between inflation and labour market strength. As unemployment rises, demand declines, driving down inflation. So, the theory goes, to kill inflation, unemployment has to rise. It's a different matter that this relationship has not held in recent decades.
Apart from this, there is another important conceptual framework which sees rising inflation as a process of reshaping of expectations towards a period of higher inflation which makes workers demand higher wages. A wage-price spiral emerges, with the trigger being wage demands. With average labour wages having risen 15% since the onset of the pandemic, this wage-price spiral framework resonates loudly in inflation debates.
Taken together, it's assumed that killing inflation requires cooling down the labour market, both at the intensive (limiting wage increase demands among existing workers) and extensive (limiting further tightening of the labour market) margins. The underlying theoretical framework is of aggregate demand increase driving up inflation.
This demand-driven-inflation assumption has been questioned in view of the obvious impact of supply shocks on the current episode of inflation. The disruptions to the global supply chains and manufacturing facilities due to the Covid pandemic was just starting to normalise when the Russians invaded Ukraine and Covid made a comeback to China. As Claudia Sahm writes,
There is no increase in the unemployment rate that would produce microchips for new cars, end China’s lockdowns, defeat Vladimir Putin, drill oil and build apartments. The Fed raises interest rates and lowers demand, cooling off the labour market. Whether it inadvertently causes a recession or not, higher interest rates would not fix the supply problems and would probably make some worse by discouraging investments.
In other words, fighting the current episode of supply-shock based inflation by raising interest rates may be barking up the wrong tree. This cure may turn out to be worse than the problem.
On an emprical note, the report points to a study by Adam Shapiro which decomposes inflation contributors and shows that less than a third of monthly core inflation is due to demand.
In addition, I see a political economy dimension to the Fed's response. In the collective consciousness of important opinion makers and decision makers, the old theoretical framework of wage-price spiral exerts an overpowering influence. This theory also fits neatly with the ideological narrative which posits capital and labour as the all-time antagonists. The establishment at all levels therefore have a strong collective resolve in keeping the bargaining power of labour constrained.
So, even at the cost of increasing their borrowing cost and also triggering a recession, I'm inclined to argue that the establishment (Wall Street, opinion shapers, and decision makers) would prefer to nip in the bud any revival of labour's bargaining power and the attendant possible wage-price spiral. Even if there is no overt conspiracy to do the same, this motive is baked into the collective consciousness of the establishment as to be a reflex response.
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