For 20 years, Fed has kept interest rates low. Why this is worrisome as inflation returns

·5 min read

Inflation remains in the news and concerns the public. And rightly so: Rising prices of necessary consumer goods are the very definition of a “pocketbook issue.”

One reader wonders about “the correlation between inflation and interest rates,” and asks, “why the Fed is turning ‘a blind eye’ to inflation while ignoring adjusting interest rates.”

That message was timely, hitting my inbox two days prior to the Labor Department’s release of June’s Consumer Price Index, showing a 5.4% increase in prices over June 2020 — the biggest year-on-year change in 13 years.

Ed Lotterman
Ed Lotterman

June also was the second month with a headline-grabbing CPI increase. The data led many to question the calm blandishments of Federal Reserve Chair Jerome Powell, who continues to deem these as temporary spikes from natural twitches in a post-COVID economy struggling back to full production.

Treasury Secretary Janet Yellen, who has held one Fed leadership position or another for most of the past 27 years, was less cheerful, warning of “several more months of rapid inflation” before prices return to levels common prior to COVID.

So start with the first question, the correlations between inflation and interest rates. The two are related in that both are rooted in the quantity of money available for households and businesses to spend, borrow and save. But they are not closely “correlated” across time.

Broadly, this “money supply” is the total of all currency, coins and bills, in circulation plus deposits in banks. The money supply, relative to the amounts of goods and services offered for sale, drives inflation. If the money supply grows faster over a certain period than output of goods and services, prices of these tend to rise. This is inflation. If the money supply grows more slowly than output, prices fall. There is deflation.

While virtually all economists still see this basic dynamic — available money versus available goods and services — as the underlying determinant of general price levels (another way of saying inflation and deflation), the relationship not nearly as direct and instantaneous as long assumed.

By conventional wisdom, postulated by Nobelist Milton Friedman, the degree of money-supply expansion the Fed implemented from 2009 to now should have caused roaring consumer inflation very quickly. It hasn’t. This leads some to argue “we are in a new economy.” This echoes, “this time it is different” — the most dangerous words in centuries of economic history.

Now look at interest rates, the second part of our reader’s question. Just as there are markets for goods and services, there are other markets for money itself. Not everyone holding money wants to buy things right now. They may prefer to hold it now so they can spend in the future.

Meanwhile, they want to earn the highest possible return on it. They essentially charge other people, who want to spend more money now than they currently own and thus borrow. Money from savers is loaned to borrowers for a fee, largely through the intermediaries of banks and other financial institutions.

It is willingness to save and lend money relative to desire to borrow and spend money that determines prices for the use of money. These are interest rates.

Importantly, this availability of money affects both changes in the general price level, such as those we are witnessing now, and interest rates.

Any central bank, such as our Federal Reserve, has the power to change the money supply at the stroke of a pen or computer key. It can create it out of nothing, and it can destroy it just as easily.

When the Fed creates more money, this lowers interest rates and makes it easier for people to spend and for businesses to invest in new plants and equipment. It alerts people that saving will yield lower returns. Spend rather than save.

When the Fed reduces the money supply, interest rates rise, consumers spend less and businesses reduce expansion. Growth of economic output slows and may actually shrink. This is a recession.

Now let’s consider what’s happening today. The higher CPI numbers tabulated in the last few months are, as Fed officials and their supporters argue, mostly related to quirks in an economy coming out of a very unusual recession caused by the external shock of the worst pandemic in a century.

Lumber prices spiked as people started projects at home and those still employed, mostly higher income white-collar workers, looked for better houses. All the while, hands-on employers like lumber mills, affected by COVID-related worker-distancing requirements and workers out sick, ran at reduced capacity. But these prices are coming back down.

Air travel collapsed, as did tourist activity generally. Car-rental companies, which usually turn their fleets rapidly, did not buy new cars and did not release tens of thousands of low-mileage used cars into markets. Used car prices spiked. Shut-down computer chip manufacturers are slow in getting back to full capacity. The list goes on.

So one response to the “blind-eye” is that current inflation is temporary. Powell stresses this, but Yellen just threw at least a small bucket of water on his optimism.

The other view is that we have had the longest and largest peacetime expansion of the money supply in more than a century. The Alan Greenspan-led Fed was very tight in the 1990s. President George H.W. Bush rightly complained, “I reappointed him and he disappointed me.” After the 1990s initial slowness, the economy grew well and federal finances were in better shape than in decades.

The 9/11 attacks blew monetary restraint apart. Then there was the financial market debacle of 2007-09. And now we have had COVID. The upshot is that the Fed has kept money plentiful and interest rates low for over 20 years. This is unprecedented, and the Fed and other central banks will have to unwind this excess.

The problem is that for 20 years, “now is not the time” has been the watchword at the Fed, from chairs Greenspan to Ben Bernanke to Yellen to Powell. But the longer we choose to not taper back, the less control we will have over when and how drastically markets will force that tightening.

Economist and writer Edward Lotterman, a former Idaho Statesman columnist and now an occasional contributor, can be reached at stpaul@edlotterman.com.

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