The Federal Reserve’s Tools Will Not Solve Inflation

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  1. What Is a Soft Landing in Economics?
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“If making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”

— Ben Bernanke (Former Fed Chair)

The Federal Reserve, headed by Jerome Powell, has made a move to increase interest rates by 50 basis points to combat rising inflation that has reached 40-year highs.

The ideal outcome of increasing interest rates is to make borrowing more expensive, cooling down business and consumer spending. In turn, this would lead to a lower inflation rate. However, the tool is blunt and, thus, risks a recession.

Therefore, the Fed is attempting a soft-landing.

A soft-landing refers to a moderate economic slowdown without triggering a recession.

This is a difficult task as, during the last five instances when inflation peaked above 5%, a recession followed right after.

Furthermore, the tools used by the Federal Reserve are not precise and, thus, can lead to a myriad of unexpected consequences.

Inflation is Beyond the US

The rise in prices is not solely within the Fed’s control.

The war in Ukraine has led to high oil prices as countries abandon Russian oil. This caused crude oil prices to spike, sparking concerns of a trickling effect down the chain.

Even though the US is no longer a huge importer of crude oil, the economy is still vulnerable to indirect effects, such as more expensive food imports.

Furthermore, China’s zero-COVID policy has led to consistent supply chain disruptions. Therefore, with tightening supply and increased demand, prices will rise.

These factors are just a few examples whereby increasing interest rates will not cool inflation.

It takes more than just the Fed to bring inflation back down.

Maintaining a Stable Employment Rate

The US is facing a tight labour market. However, due to the Great Resignation, workers are quitting in droves.

This pushed businesses to increase their hourly rates and provide bonuses to attract new workers. Unfortunately, this led to a wage-price spiral as businesses dumped the increased cost of workers onto consumers.

Increasing interest rates could do the opposite. As businesses find it more expensive to borrow, they might not see the need to hire as many workers. Some businesses might even lay off workers.

This becomes a balancing act for the Fed.

On the one hand, the Fed wants to achieve maximum employment, but on the other hand, increasing interest rates could lead to higher unemployment.

Conclusion

Finding the sweet spot that could reduce inflation yet maintain economic growth can be tricky. To some economists, it is nearly impossible.

Regardless, the Fed will try its hardest to bring inflation back down, as not doing so could lead to an event akin to the Great Inflation of the 1970s.

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