Fighting the last war

It’s often said that generals are always ready to fight the last war, and it seems the same applies to the U.S. Federal Reserve when it comes to its ongoing battle with inflation. Central bankers are good students of history, but that doesn’t always provide them with a crystal ball, as their latest efforts to reduce inflation have demonstrated.
Interest rates are a blunt, and occasionally self-defeating, approach to taming inflationary pressures, and that’s particularly true when many of the factors fueling inflation are outside the control of such economic forces, or don’t apply given some of the structural changes that have occurred in the U.S. and global economy.
The impact of the COVID-19 pandemic has been extraordinary. The world as we understood it before COVID is gone and is not coming back. Major global events invariably reshape the world in ways that are both profound and unpredictable. COVID is just the latest such event.
COVID contributed to inflation in many ways. It prompted governments to provide unprecedented levels of financial stimulus to ward off some of the worst economic effects of the pandemic. Life changed in a veritable instant for billions of people around the world as lives turned inward for months and many lost jobs or a substantial portion of their incomes. Government stimulus was critical, and it kept the global economy from falling off a financial cliff, but it ran headlong into other COVID-related developments, like supply shortages.
Among its many impacts, COVID changed our buying habits. We stopped going out and instead put money into home improvements at a time when many of the factories that produced the products that went into construction materials and home furnishings were shuttered, operating with far fewer workers, or couldn’t get basic materials they needed for production. The inevitable shortages sent the price of construction materials skyrocketing.
This was one side of inflation that the Federal Reserve could actually address. Higher interest rates have slowed new home buying and construction and the price of building materials have dropped accordingly. Housing prices have dropped as well, which may count as a win on the inflation front, but that doesn’t mean houses are more affordable for anyone who has to rely on mortgage financing. And the construction of fewer new houses won’t help address the problem of affordability in the longer term, either.
Interest rates may be a weapon in the fight against inflation, but it’s clearly a double-edged sword. That’s particularly true in the aftermath of COVID, since supply shortages resulting from the pandemic fueled higher prices. In a supply and demand system, expanding supply is one way to bring down prices for goods, but that’s increasingly prohibitive given high interest rates. The cost of a factory expansion has gone up considerably due to the Fed’s actions over the past 12 months.
What’s more, a number of factors behind the rising cost of food in the past couple years really can’t be addressed by adjustments in interest rates. The price of eggs and poultry have jumped because of the worst outbreak of avian flu on record, which has devastated many poultry and egg producers and reduced supply.
War in Ukraine, long one of the world’s bread baskets, has pushed the price of many grain-dependent products higher. Fertilizer costs have jumped sharply as well, since Russia was a major supplier and is now under sanctions. Sanctions against Russian oil have kept gas prices higher as well.
At the same time, the impacts of climate change are making themselves felt in terms of inflation. California’s Central Valley, which has long grown the bulk of U.S. produce, has been subjected to everything from extreme drought to unprecedented flooding in the past two years. That means that head of lettuce or salad mix is going to cost you more. And there’s nothing interest rate adjustments can do about that. And don’t expect that situation to get better in our lifetimes. Climate change is going to raise the cost of many things and we’re only beginning to experience the implications.
The bottom line is that we need more creative and multi-faceted solutions to the challenges posed by inflation. There’s a role for government policymakers here as well, not just central bankers, who often don’t consider some of the impacts of their decisions on average people since they don’t regularly face voters.
Unfortunately, effective action out of Washington would take bipartisan agreement, something that seems almost impossible right now, given those currently in charge in the House. Which is why we’ll probably be dependent on the blunt tool of interest rates in the fight against inflation for the foreseeable future.