Raising US interest rates won’t help to arrest skyrocketing prices as it did under the Volcker shock
NEW YORK – Economic models, the distinguished Canadian economist Reuven Brenner notes, resemble the grass models of American planes and airfields constructed by the New Guinea Cargo Cults of the 1940s. By building fetishes that resembled the aircraft that brought cargo to New Guinea during the war, the cultists believed, they, too, would attract cargo from the skies.
The Federal Reserve’s faith in its models is touching, but less excusable than the mistake of the paleolithic tribesmen of New Guinea. As the worst inflation in 40 years became manifest starting a year ago, the Federal Reserve repeatedly denied that it was happening and that rising prices were only “transitory.”
Now that it is upon us, the Federal Reserve is raising interest rates and tightening credit conditions as a putative remedy.
The Fed can control one thing, and that is the expansion of credit in the banking system. Bank credit to businesses (commercial and industrial loans), though, has been falling for the past two years, as the above chart shows.
That is radically different from the circumstances that prompted the late former Federal Reserve chairman Paul Volcker to aggressively raise interest rates in 1979. I reviewed the history in a January 28 analysis for Asia Times.
Shown in the chart below is the annual percentage change in bank holdings of business loans versus bank holdings of government securities. In 1979, bank credit grew at a blistering 20% a year, as businesses splurged on hard goods that they expected to cost more in the future.
That is the sort of inflationary cycle that justifies a tightening of credit conditions. Volcker did so, and it worked. Shortly afterward, the Reagan administration passed the Kemp-Roth tax cuts which provided stimulus to the economy, and the US economy bounced back.
During the past year, bank credit has shrunk by about 10%, the worst contraction on record after the Great Recession of 2008-09. Today’s inflation stems from $6 trillion in federal stimulus, which increased demand while removing incentives to work. The Labor Force Participation Rate still hasn’t recovered to pre-Covid levels. Demand is huge and labor is scarce.
But the Fed’s models state that tightening credit conditions is the cure for inflation. That’s the Fed’s story, and it’s sticking to it. If the Fed succeeds in pushing the US economy into recession, it will claim success.
If the $6 trillion in fiscal stimulus is followed by a recession, demand will fall and prices will stop rising, to be sure. But the $6 trillion stimulus was supposed to prevent a recession, and curing its effect by bringing about exactly what it was supposed to prevent is absurd.
The core problem is sclerosis in US supply chains. US manufacturers couldn’t find enough labor or capital to meet the boost in demand, so the United States imported more goods. As the chart above shows, America’s net imports of manufactures (the manufacturing trade deficit) roughly doubled during the Covid epidemic, from about $50 billion a month to around $100 billion.
Instead of multi-trillion dollar handouts, the US needs support for manufacturing in the form of apprenticeship programs for skilled workers, educational subsidies for engineers, easier tax conditions on long-term capital investment, regulatory breaks, and selective subsidies. Today’s inflation is the result of a failure of the US economy to provide additional supply. It is a structural problem long in the making.
Higher interest rates won’t help. As I pointed out on January 28, higher mortgage rates will price many homebuyers out of the market, forcing them into rentals. And rents contribute more to inflation than any other good or service.
Rising interest rates will thus probably make inflation worse. It’s time to think about economics differently and give up the Fed’s outdated fetishes.
Asia Times