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The FED fails to control inflation. The long-term view

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 In January 2022, we wrote in this blog about the strict proportionality between the CPI inflation and the actual interest rate defined by the Board of Governors of the Federal Reserve System, R. This previous post continued the thread of posts related to this issue. Briefly, the cumulative interest rate since the mid-50s is just the cumulative CPI times 1.37. Interestingly, there are periods when the interest rate deviates from the long-term inflation trend, which has been almost linear since 1972. Here, we extend the observational dataset to the period of the quickest inflation rise since the second part of 2021, and discuss the most probable reason why the FRS actually does not control inflation as such by presenting the actual economic force behind price inflation, as we described in a series of papers [e.g., 123, and 4].  Overall, inflation is a linear lagged function of the change in the labor force. The latter is driven by a secular change in the participation rate in the labor force (LFPR) together with a general increase in the working-age population. In other words, increasing the labor force pushes inflation up, and decreasing the labor force leads to price deflation. The period of the COVID-19 pandemic is the first one when helicopter money flooded the US economy and the inflation effect observed in 2021 and 2022 is fully explained by the natural dollar devaluation related to money excess (see this post).

Introducing new data obtained in 2022, we depict in Figure 1 the effective FED rate, R, and the CPI inflation as expressed in the relative growth rate (1/year). In Figure 2, R is divided by a factor of 1.37 (see our previous post for details) to match the long-term trend in consumer price inflation. Before 1980, R was rather in the leading position. Since the late 1970s, Rlags behind the CPI, i.e. inflation grows at its own rate and R just follows. The sought level of price inflation was flexible. The idea of interest rate adjustment is that a higher R should suppress price inflation. During deflationary periods with a slow economy, low (in some countries negative) R has to channel cheap money into economic growth. The reaction of inflation is also expected not shortly but with some time lag.


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