Inflation and interest rates

Many governments, including the US, gave their citizens “ayudas” to help them cope with the pandemic. As the pandemic restrictions were being relaxed, increased economic activities caused a rapid rise in consumer demand for products and services. Revenge spending was on…

Unfortunately, manufacturers couldn’t meet the sudden increase in demand because the pandemic disrupted supply chains worldwide. There were, for instance, not enough semiconductor chips to make new cars. With the limited supply of new cars, manufacturers earned more profits on fewer car sales by raising prices.

It was not just cars. Inflation was at an all time high and central banks everywhere (except Turkey) reacted by quickly raising interest rates, the orthodox cure for high inflation.

Economics is like a religion with its unquestionable dogmas. In this case, inflation and  interest rates are seen to move in the same direction, so interest rates are the primary tool used by the central banks to manage inflation. Raising interest rates is the accepted policy response to contain rising inflation. Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy.

Higher interest rates mean higher borrowing costs, contributing to higher product prices. So, people will start spending less. The demand for goods and services will then drop, which will cause inflation to fall.

Raising the interest rate also usually forces companies to lay off workers, which again reduces the amount of money in people’s pockets. It is a cruel consequence that many economists impose on everyone because to them this is the cure to high inflation.

US inflation was at seven percent, its highest level since 1982. A recent article in The New Yorker reports that economist and former Treasury Secretary Larry Summers, offered an explanation:

“The President,” he said, “had put so much money into consumers’ hands that they were now outbidding one another for ordinary household products, pushing up prices. The basic problem, according to this diagnosis, was that the American public essentially had it too good, and would have to become poorer–spend less–for inflation to abate.

“The solution pressed by Summers and like-minded thinkers was to induce millions of layoffs. By raising interest rates, the Fed could make borrowing more difficult for businesses, forcing many to cut costs by firing workers. By the spring of 2022, Summers proposed fixing inflation with a year of 10 percent unemployment–meaning 16 million people without a job.”

Isabella Weber, a young academic from the University of Massachusetts at Amherst, told The New Yorker that “It’s quite a painful way to bring inflation down.”

She explained: “The US spent a lot on economic relief during the pandemic, but so did other countries, including Japan, where inflation peaked at just 4.3 percent. If too much government spending were the problem, why weren’t all of the big spenders getting hit similarly hard?

“And if excessive household wealth were the key driver of inflation, you would expect the prices of consumer goods to rise more or less in tandem, as people bought more of everything. Instead, most inflationary pressure came from large spikes in the prices of specific products and commodities, such as natural gas…”

(That reminds me… when I was with the Ministry of Energy, we found out that after an oil price increase, our traders jacked up prices of their products beyond the contribution of the oil product price in their product cost build-up. Excuseflation in action.)

Weber asked: “What if we were thinking of inflation all wrong?” She wondered, maybe mainstream economists were looking at it from the wrong side. The focus ought to be on sellers, not buyers.

She pointed out that as the economy began opening up, corporate profits were wildly outpacing growth in consumer spending power.

Weber proposed having a “serious conversation about strategic price controls.” That caused an uproar among the high priests of economics who saw it as more than a policy suggestion. Weber was challenging an article of faith, which The New Yorker pointed out, had been emotionally charged and rarely disputed.

The New Yorker reports: “For decades, the notion of a government capping prices had evoked Nixonian cynicism or Communist incompetence. And Weber was making her case in a climate of economic fear. Although the most acute disruptions of the pandemic seemed to be over–businesses were reopening and jobs were coming back–supply chains remained snarled and prices were rising faster than they had in 40 years. Fringe fantasies of hyperinflation and economic doom were starting to go mainstream.”

Weber argued that the supply shocks of the pandemic were similar to that seen during a war. She finds it hard to see how the orthodox approach–increasing unemployment through higher interest rates–would help solve the problem.

Citing the example of carmakers, Weber writes that the chip shortage established a “temporary monopoly” that allowed automakers to “raise prices without having to fear a loss in market share.” And it wasn’t just chips. Firms in a variety of industries knew they could get away with gouging customers. Weber calls this dynamic “sellers’ inflation,” in contrast with the traditional model of inflation, in which an excess of consumer purchasing power is to blame. What’s happening is Greedflation.

Weber argued, it is possible to limit inflation without inducing layoffs and wage cuts. But it involves strategic price control. Her suggestion was adopted by Germany that imposed price brakes on natural gas.

From The New Yorker: “Weber’s fundamental point that corporate profits are a key driver of today’s inflation is now openly embraced by the establishment on multiple continents. Researchers at the Kansas City Federal Reserve recently concluded that corporate price markups may have accounted for more than half of the inflation experienced by the US in 2021.”

The New Yorker also reports that Weber is enthusiastic about a proposal from the New York attorney general’s office to strengthen the state’s price-gouging regulations. The new rules would scrutinize price increases of 10 percent or more during a period of “abnormal market disruption.”

Something to think about. Sellers induced inflation vs buyers induced inflation. Our economic managers must be able to distinguish which is which.

Boo Chanco’s email address is [email protected]. Follow him onTwitter @boochanco