Do interest rate increases fight inflation?

The Federal Reserve fights inflation by raising interest rates. Here is an amalgam of what several sources say”

The Fed’s primary tool it can use to battle inflation is interest rates. It does so by setting the short-term borrowing rate for commercial banks, and then those banks pass it along to consumers and businesses.

That rate influences everything from interest on credit cards to mortgages and car loans, making borrowing more expensive.

Inflation is a general increase in prices. So, how does making borrowing more expensive affect inflation? Shouldn’t an increase in borrowing costs make products and services more expensive rather than less?

The answer is “Yes.” Interest is a cost that manufacturers, farmers, and services must add to prices, so they can make a profit.

The Fed aims to make borrowing more expensive so that consumers and businesses hold off on investing, thereby cooling off demand and bringing prices back in check.

How does reducing investments “cool off demand”? 

Higher interest rates might reduce the demand for large consumer items, like houses and cars. But does reducing investments reduce your demand for food?  Does it reduce your need for oil? For clothing?

Think of everything you buy? Which of those things will you buy less because interest rates went up? Probably, none.

The Fed believes that inflation is caused by (in their words) “an overheated economy.” But what is an overheated economy?  Here is what the Bing Artificial Intelligence (AI) says: 

An overheated economy is when the economy grows too fast. An overheated economy reaches the limits of how much output it can produce to meet the demand from consumers and businesses, as there are minimal unused resources.

In short, inflation is a supply problem. The Fed’s “overheated economy” is one where supply can’t meet demand.

The Fed’s inflation cure is to increase interest rates which reduces business investment and supply.

The Fed hopes that increasing interest rates will reduce demand more than supply, but what do we call reduced demand? Recession.

If the Fed’s approach is correct, we should see two things that we do not see:

1. We should see that rising interest rates do not cause recessions
2. We should see that falling interest rates do not cure recessions
3. We should see that rising interest rates precede (i.e., cause precedes effect) falling inflation.

Look at the graph below, and you will see the opposite. In fact:

1. Rising interest rates lead to recessions (vertical gray bars).
2. Falling interest rates help cure recessions
3. Rising inflation precedes rising interest rates (cause precedes effect).

As for #3, rising inflation precedes interest rate increases because the Fed reacts to inflation increases by raising rates.

Then after inflation begins to come down, the Fed lowers rates.

While the Fed claims that rising interest rates cause inflation to fall, rising inflation leads to higher interest rates.

Imagine the car going faster causes the driver to press the gas pedal down further. Inflation causes the Fed to increase interest.

What is the cause and cure for inflation if interest rate increases are recessionary and don’t cure inflation?

The cause and cure for inflation lie in the supply of oil.

As opposed to common knowledge, the Fed’s interest rate increases do nothing to reduce inflation, which parallels oil prices and is determined by oil supply.

To the degree interest rate increases may reduce the oil demand, they cause recessions.

Until renewables become a more significant part of our energy supply, a reduced need for oil will signal recession.

Congress and the President have assigned the Fed the task of controlling inflation. But though the Fed doesn’t have the tools to manage inflation, Congress and the President do.

Short term, there should be federal incentives for drilling and refining oil. Longer term, the efforts to reduce oil usage via renewables should be accelerated with federal subsidies and tax credits.

More significant incentives for electric car purchases and usage, incentives for solar, wind, geothermal, and nuclear power production would do far more to reduce inflation, without a recession, than interest rate increases.

Congress and the President don’t want the inflation responsibility. The Fed does want the responsibility because it gives them greater power.

Currently, the Fed is like the child sitting in the back seat, furiously spinning his toy steering wheel. He thinks he steers the car, just as the Fed believes it steers the economy, when Congress, the President, and the world’s oil producers steer it.

The Fed’s money tinkering is but a blip on the screen.

Curing shortages, particularly oil shortages, but also renewable energy, food, computer chips, transportation, vital chemicals, and other shortages are needed to control inflation.

Rodger Malcolm Mitchell

Monetary Sovereignty Twitter: @rodgermitchell

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