The cause and cure for inflation. A discussion with the AI, Copilot.

Copilot seems to be a fairly good Artificial Intelligence system. However, it suffers from the same problems all AIs do: They gather and spit out information and often don’t comprehend logic.

While discussions with Copilot can be frustrating — it hardheadedly repeats what it already has said and often doesn’t respond to your argument — it does help reveal counter-arguments you may not have considered.

That said, I enjoy seeing what the world (i.e. the world that AI samples) says about various ideas. After all, Copilot reads far more than I can, so it usually represents most common beliefs.

Here is an example of my discussion with Copilot regarding the cause and cure for inflation. If you never have had a discussion with AI, you especially will find this enlightening:

You
Virtually all businesses borrow and/or use materials made by companies that borrow. Interest is a cost. Businesses price their products to make a profit over costs.

Therefore, increasing interest rates increases business costs, which in turn increases the prices of nearly all goods and services. Is this correct? If not, why?

Copilot
You’re on the right track! When interest rates rise, businesses can face several challenges that impact their costs and pricing.

Here’s how it works:

Reduced Ability To Service Debt: Rising interest rates increase the cost of borrowing.

If a business has existing debt with variable interest rates, servicing that debt becomes more expensive.

This can strain cash flow, leaving less capital available for other investments or operational expenses. As a result, businesses might prioritize debt payments over growth initiatives, potentially limiting their overall potential.

Slower Growth: Access to capital is crucial for business expansion. When interest rates go up, borrowing becomes costlier.

Businesses may scale back growth plans to avoid excessive liabilities relative to their income. This slower growth can impact their ability to introduce new products, expand operations, or invest in marketing.

Consumer Purchasing Power: Higher interest rates affect consumers too. Borrowing costs for personal expenses (like mortgages and car loans) increase, reducing consumers’ purchasing power.

When consumers spend less, businesses may face decreased demand for their goods and services, impacting revenue and profitability.

In summary, rising interest rates can indeed lead to increased business costs, affecting pricing and growth.

Business owners must carefully manage their capital structure and adapt to changing economic conditions to maintain competitiveness and profitability.

You
If, as you say, “rising interest rates can indeed lead to increased business costs, affecting pricing and growth,” raising interest rates to combat inflation is counterproductive.

Those higher interest rates cause higher prices. True?

Copilot
You’ve raised an interesting point! Let’s delve into this further.

When central banks raise interest rates to combat inflation, their primary goal is to manage the overall economy. Here’s how it works:

Controlling Inflation: Inflation occurs when the general price level of goods and services rises over time. Central banks aim for moderate inflation (usually around 2%) to promote economic stability. If inflation exceeds this target, it can erode purchasing power and disrupt economic equilibrium.

Interest Rate Impact: Central banks adjust interest rates (usually the policy rate) to influence borrowing costs. When rates rise:

Borrowing Costs Increase: As you rightly pointed out, businesses face higher borrowing costs. This affects their investment decisions and can slow down economic activity.

Consumer Spending: Higher interest rates also impact consumers. Mortgages, car loans, and credit card rates increase, reducing disposable income. Consumers may cut back on spending, affecting demand for goods and services.

Trade-Off: Central banks face a trade-off. If they keep interest rates too low for too long, inflation can spiral out of control. Conversely, if rates are too high, economic growth may suffer. Striking the right balance is crucial.

Expectations Matter: The impact of interest rate changes depends on expectations. If businesses and consumers believe that higher rates will curb inflation, they may adjust their behavior accordingly. This can mitigate the impact on prices.

In summary, while raising interest rates can lead to higher business costs and potentially impact prices, central banks use this tool strategically to manage inflation and overall economic health.

It’s a delicate balancing act, and the effectiveness varies based on the specific context and expectations within the economy.

You
You said, “while raising interest rates can lead to HIGHER BUSINESS COSTS and potentially impact prices, central banks use this tool strategically to manage inflation.”

In short, the Fed increases prices to combat increased prices. Does this make any sense?

Copilot
I apologize if my previous explanation caused confusion. Let’s clarify:

Interest Rates and Inflation:
Central banks raise interest rates to manage inflation, not to directly increase prices.
The goal is to strike a balance between controlling inflation and supporting economic growth.

By adjusting interest rates, central banks influence borrowing costs, which in turn affect spending and investment decisions.

Mechanism:
When interest rates rise:

Borrowing Costs Increase: Businesses face higher costs for loans, impacting their investment decisions.

Consumer Spending Adjusts: Consumers pay more for mortgages, car loans, etc., reducing disposable income.

These adjustments can slow down economic activity, potentially curbing inflation.

Complex Dynamics:
It’s not a straightforward “increase prices to combat increased prices” scenario.
Central banks consider various factors, including inflation expectations, economic growth, and employment.

Their actions aim to stabilize the economy, even if the immediate impact involves adjusting costs.
In summary, while the relationship between interest rates and prices isn’t linear, central banks use this tool strategically to maintain overall economic health. It’s a nuanced process, and the ultimate goal is stability.

You
I still don’t see how increasing business costs combats higher prices.

Copilot
I apologize for any confusion. Let’s break it down further:

Interest Rates and Business Costs:
When central banks raise interest rates, it affects businesses in several ways:

Borrowing Costs: Businesses pay more for loans, impacting their expenses.

Investment Decisions: Higher costs may lead to reduced investment in expansion, research, or new products.

Cash Flow Constraints: Debt payments become costlier, affecting cash flow.

Impact on Prices: While higher business costs don’t directly combat inflation, they influence pricing indirectly:

Supply-Side Constraints: If businesses face higher costs, they may pass some of it on to consumers through higher prices.

Demand-Side Effects: Reduced consumer spending due to higher rates can dampen demand, affecting overall price levels.

Complex Dynamics: It’s not a direct cause-and-effect relationship. Central banks aim for a balance:

Inflation Control: They raise rates to prevent runaway inflation.

Economic Growth: But they also consider growth and employment.

In summary, the connection isn’t straightforward, but central banks use interest rates strategically to stabilize the economy. The goal is to manage inflation while supporting growth.

You
You said, “Businesses pay more for loans, impacting their expenses” (which requires businesses to raise prices.) “Higher costs may lead to reduced investment in expansion, research, or new products” (which reduces supply, thereby causing shortages that lead to higher prices.) And,

“Debt payments become costlier, affecting cash flow” (which requires businesses either to raise prices or reduce production.)

And, “Reduced consumer spending due to higher rates can dampen demand, affecting overall price levels” (Dampening demand is recessionary.)

Put them all together, and you’re saying, in essence, that the Fed fights inflation by causing inflation and/or by causing a recession.

Copilot
Thank you for your thoughtful analysis! Let’s untangle this complex web of economic dynamics:

Interest Rates and Business Costs:
When interest rates rise, businesses indeed face higher costs for loans.
This can impact their expenses, cash flow, and investment decisions.

Supply-Side Effects:
Higher costs may lead to reduced investment in expansion, research, and new products.
Reduced supply can potentially cause shortages, which could contribute to higher prices.

Consumer Spending and Demand:
Higher rates also affect consumers:

Mortgages, car loans, and credit card rates increase.
Reduced consumer spending can dampen overall demand for goods and services.

The Fed’s Balancing Act:
Central banks, including the Federal Reserve (the Fed), face a delicate balancing act:

Inflation Control: They raise rates to prevent runaway inflation.
Economic Growth: But they also consider growth and employment.
Their goal is stability, not necessarily causing inflation or recession.

Complex Trade-Offs:
The relationship isn’t linear:

Short-Term Pain: Higher rates can cause short-term challenges (like reduced investment).
Long-Term Gain: But they aim for long-term stability and sustainable growth.

In essence, the Fed’s actions involve trade-offs, aiming to manage inflation without causing severe disruptions. It’s a nuanced dance, and the ultimate goal is a healthy economy.

You
Rather than fighting inflation by raising business costs and/or causing a recession, the Fed should admit it does not have the correct tool to fight inflation.

Congress and the President have the correct tool: Spending some of the government’s infinite supply of dollars to acquire and distribute the goods, the scarcity of which causes inflation.

For instance, when oil is scarce we have inflation. Federal spending to encourage drilling and refinining oil would cure many inflations.

Federal spending to help farmers grow more food and manufacturers to create more steel, computer chips, shipping, logging, etc., would lower the prices of food, steel, etc.

The Fed has one tool — interest rates — and it is the wrong tool.

Copilot
You’ve raised an important debate about inflation-fighting tools. Let’s explore the roles of both monetary policy (controlled by the Federal Reserve) and fiscal policy (controlled by Congress and the President):

Monetary Policy (Federal Reserve):
The Federal Reserve primarily uses interest rates to influence the economy.
When inflation rises, the Fed may raise interest rates to:

Reduce borrowing and spending.

Slow down economic growth.

Mitigate inflationary pressures.

Fiscal Policy (Congress and President):
Fiscal policy involves government spending and taxation.

Here’s how it can combat inflation:

Targeted Spending: Congress can allocate funds to specific sectors (like oil drilling, food production, or steel manufacturing) to increase supply and reduce scarcity.

Infrastructure Investment: Investing in infrastructure (roads, bridges, etc.) can boost productivity and reduce bottlenecks.

Subsidies: Subsidies for essential goods (like food) can stabilize prices.

Tax Policies: Adjusting taxes can impact consumer spending and business investment.

Complex Interplay:Both monetary and fiscal policies have strengths and limitations.

The Fed’s interest rate tool isn’t the only lever—it’s complemented by fiscal decisions.

In summary, a holistic approach that combines both monetary and fiscal measures is crucial for effective inflation management. 

You
Agreed, with one exception. In the real world, monetary policy never has reduced inflation, though it can cause a recession.

Historically, all U.S. recessions have begun with reduced deficits.

On the other hand, fiscal policy does work—it is the only policy that works. However, Congress is reluctant to accept responsibility for controlling inflation and would prefer to blame the Fed for inflation.

Copilot
You’ve highlighted an essential debate about inflation-fighting tools, and it’s a nuanced discussion. Let’s explore the roles of both monetary policy (controlled by the Federal Reserve) and fiscal policy (controlled by Congress and the President):

Monetary Policy (Federal Reserve):

The Federal Reserve primarily uses interest rates to influence the economy.

When inflation rises, the Fed may raise interest rates to:

Reduce borrowing and spending.
Slow down economic growth.
Mitigate inflationary pressures.

Fiscal Policy (Congress and President):

Fiscal policy involves government spending and taxation.
Here’s how it can combat inflation:

Targeted Spending: Congress can allocate funds to specific sectors (like oil drilling, food production, or steel manufacturing) to increase supply and reduce scarcity.

Infrastructure Investment: Investing in infrastructure (roads, bridges, etc.) can boost productivity and reduce bottlenecks.

Subsidies: Subsidies for essential goods (like food) can stabilize prices.

Tax Policies: Adjusting taxes can impact consumer spending and business investment.

Complex Interplay: Both monetary and fiscal policies have strengths and limitations.

The Fed’s interest rate tool isn’t the only lever—it’s complemented by fiscal decisions.

In summary, a holistic approach that combines both monetary and fiscal measures is crucial for effective inflation management.

While monetary policy plays a role, fiscal policy remains a powerful tool in the fight against inflation.

Copilot hasn’t convinced me that “monetary policy plays a role,” primarily because I disagree with the notion that recessive policy is better than growth policy.

But it was good to see what I assume to be most of the Fed’s arguments, faulty as they may be, spelled out concisely. 

What do you think?

Rodger Malcolm Mitchell
Monetary Sovereignty

Twitter: @rodgermitchell Search #monetarysovereignty
Facebook: Rodger Malcolm Mitchell

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The Sole Purpose of Government Is to Improve and Protect the Lives of the People.

MONETARY SOVEREIGNTY