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Is there a point where raising interest rates increases inflation?
Everywhere you look, everyone is talking about is “inflation.” And, even though the term is often used incorrectly in the press (if inflation stops, it doesn’t mean prices fall), runaway inflation is economically destructive in the long run.
In Paradigm Shift: Rethinking Housing Affordability, I talked about how California housing laws intended to increase housing construction has, paradoxically, failed to do so. And, since housing construction and real estate prices are greatly impacted by high interest rates and the cost of borrowing, is it is something that should be on the minds of all California legislators.
Higher for longer
Conventional wisdom tells us that,
“By increasing borrowing costs, rising interest rates discourage consumer and business spending, especially on commonly financed big-ticket items such as housing and capital equipment. Rising interest rates also tend to weigh on asset prices, reversing the wealth effect for individuals and making banks more cautious in lending decisions.”[1]
According to this theory, the Fed has to raise unemployment and increase personal suffering to save the economy from itself. But there’s always been something about this that feels perverse and I think a lot of people who are already struggling and feeling left behind in our economy are demoralized by it or just plain resent the hell out of it.
In its single-minded determination to reduce inflation, the U.S. Federal Reserve seems hell-bent on driving the country’s surging economy to the breaking point by keeping interest rates higher for longer. Their actions are having dramatic impacts on the costs of everything in our lives. But, what if at a certain point in the unusual economic cycle we find ourselves in, increasing rates and the cost of doing business is contributing to inflation’s stubborn persistence?
Some economists argue that contrary to conventional wisdom, there is evidence that at certain points in the economic cycle, and particularly in our unusual pandemic rebound times, higher interest rates can actually increase inflation, not lower it. They say, the Fed is basing its definition of success on an archaic textbook macroeconomics standard to justify its simplistic monetary policies. Its goal is to sacrifice the well-being of ordinary workers to achieve the “inflation Holy Grail of 2 percent, a figure made up out of thin air some 30 years ago.”[2]
Since 2022, Nobel Prize-winning economist and Columbia University Professor Joseph Stiglitz has argued that hiking [and keeping] interest rates “too high, too fast, too far” will stoke inflation in goods and housing. And because housing prices are “not going to come down as fast as interest rates are going up and that’s going to increase the inter-generational divide in our society.” (His comment seems prescient now.)
Stiglitz has also been arguing that what is fundamentally wrong with Fed policy is that rate hikes, alone, fail to address the main source of this particular inflation cycle that was set off by supply-side bottlenecks, instead of too much demand.
In October of 2022, he wrote,
“Since the onset of post-pandemic inflation, there have been two schools of thought about the causes and the cure. One was based on standard macroeconomics: There had been excessive aggregate demand, fueled by excessively generous relief money to those struggling during the pandemic. The cure was standard too: tight monetary policy, until workers felt enough suffering to cry uncle, accepting declines in living standards and lower real wages, thereby reducing wage and price pressures.
“The other school of thought focused on the unique characteristics of the pandemic and the war in Ukraine—the way in which these events induced changes in where people wanted to live and how they worked, as well as the extent of supply chain interruptions. Once the pandemic passed and markets had a chance to adjust, the surge in inflation would pass.”
Stiglitz now believes the conventional wisdom has been proven wrong and the alternative view has been proven correct. He contends that the Fed's rate increases had little to do with why inflation started (supply chain constraints) and why it started to come down even before the Fed had significantly raised rates.
He notes,
“Inflation was coming down even the Fed had done nothing. This is not to deny that increases in interest rates and reductions in credit availability do lower aggregate demand, and in doing so add to the disinflationary pressures. But their actions were not at the center of what happened; they cannot be given credit. Indeed, with U.S. GDP growing in the third quarter at 4.9 percent, it’s hard to believe that it was a weak economy that brought down inflation. Indeed, in many ways the Fed made things worse. It was more difficult to make the investments required to alleviate shortages. Higher interest rates made housing less affordable and less abundant.”
A paper by Mike Konczal at the Roosevelt Institute shows that the overwhelming part of the reduction in prices we’ve experienced in the past year can be explained by supply-side increases, not the Fed’s interest rate increases.
The great risk in all this is the lag effect of maintaining high interest rates (increases in interest rates do not show up on economic measurements for as long as a year after the fact) will hurt the economy unnecessarily and will keep inflation from falling further because it is discouraging growth and capital investment in systemic cures for supply chain shortages and cost reduction measures.
The risks are even more treacherous when the Fed targets a “desired unemployment rate” that they think means their tight monetary policy is “working.” The question is, working for whom?
As Stiglitz notes,
“Targeting an average unemployment rate of just 5 percent implies an unemployment rate of some disadvantaged groups much, much higher—in recent months, African American youth unemployment has been running at three to six times the average rate. Such high rates would almost certainly leave long-term collateral damage.”
In sum, because the Fed believes that our inflation problems are driven solely by excess demand created by government spending during the pandemic, its monetary policy doesn’t consider the underlying supply problems and by trying to kill the economy with higher interest rates, it hurts smaller companies but those who have dominant pricing power (oil, tech, banking, etc.) will still increase prices to pass along costs.
Stiglitz concludes,
“At best, inflation would have been slain but only at the cost of very high levels of unemployment.”
Inflation is about much more than supply and demand
The impacts of high interest rates on our economy are complicated. High interest rates increase business costs (higher borrowing costs), which get passed on to consumers through higher prices, exacerbating inflation. This is known as "cost-plus pricing.” And since most companies in high-growth sectors of our economy carry significant debt and are valued based on their profits, when borrowing costs rise, companies will automatically raise prices to maintain their profit margins and their stock price, adding to the price of everything from raw materials to consumer goods.
As such, Stiglitz and others contend that inflation is a lot more complicated than just hitting the brakes or hitting the gas on the economy and inflation is “expressed” in many ways that don’t show up on government statistical measurements.
For example, higher interest rates/costs of doing business quickly result in,
Shrink-flation: Product manufacturers maintain the same price for their product but reduce the amount in the package, bag, or box, e.g., fewer chips and smaller candy bars for the same price.
Greed-flation: A product manufacturer or commodity producer claims that they have to increase their pricing because of inflation, even when that’s not the case. We see this kind of price gouging most egregiously with gasoline prices, the proof being that the Exxon’s of the world enjoyed record profits during and since the pandemic by falsely claiming that ‘inflation made us raise prices.’ Many other industries also did this during and after the pandemic, cashing in on what they saw as a unique opportunity to raise prices and increase profits.
Fear-flation: Workers start demanding higher and higher wages and benefits because they fear that the present steep trajectory of price increases will continue forever.
All this considered, the Fed’s determination to raise interest rates until the economy feels the pain can throw fuel on the inflation fire because it’s quickly translated into higher prices for just about everything.
Nowhere is this more concerning than how it impacts housing prices and rents. Again, Stiglitz and others argue that high interest rates and the overhanging constant threat of more rate hikes in the future are counter-productive and can be a major contributor to housing unaffordability.
(See Paradigm Shift: Rethinking Housing Affordability for a deeper analysis of the other factors contributing to our national “unaffordability” crisis, which has been 40 years in the making.)
Higher interest rates decrease housing affordability
It doesn’t take a PhD to understand that the difference between a 3% mortgage payment and a 7% mortgage payment has an enormous impact on housing demand, housing construction, and overall housing market liquidity. As mortgage rates rise, both supply and demand are constrained because:
- Fewer people can qualify for a conforming loan (i.e., a loan that meets Fannie Mae and Freddie Mac lending standards: down payment percentage, loan amount, credit score, debt to income ratio, loan to value percentage, etc.)
- Homeowners who already have low-interest mortgages become more reluctant to move to a new home and take on a higher mortgage payment; an
- Homebuilders stop building homes because their risk/reward calculus goes negative.
In higher-end urban/suburban markets, “higher for longer” interest rates can put upward pressure on home prices due to lack of supply, while in middle-class housing markets, pricing can reach a tipping point, as it has in Texas and Florida, where these dynamics defeat demand to a point that builders find themselves with no buyers for their homes and prices start falling even as housing construction starts fall. In markets like the San Francisco Bay Area, the net result can be an ill-liquid, pricing standoff where housing affordability does not significantly change.
Uniquely, in California, the inability to get homeowners insurance due to wildfire risk only makes matters worse by removing homes that are uninsurable from the market.
The CPI
All this is even more important because “housing” represents more than 1/3 of the Consumer Price Index (CPI), which the Federal Reserve uses to determine if their ‘raise interest rates’ campaign is working. Making matters worse, the CPI uses housing data from the Bureau of Labor Statistics based on a highly inaccurate, backward-looking calculation called “owners’ equivalent rent” that uses data that is at least 6 months old. This has zero predictive value about what will happen going forward or whether Fed policies are succeeding.
So, the Fed is using backward-looking data to decide if they should raise interest rates more to slow the economy, the impacts of which won’t be knowable until 12 months in the future. In the real world, where prices fluctuate quickly from today to tomorrow, how does this make any sense?
There are attempts underway to address this antiquated nonsense, but it is unlikely the stodgy old Federal Reserve will acknowledge them any time soon. (For more on better methods to assess inflation, see the Truflation project.) However, there is no question that the governance of our central banking system -- where a bunch of privileged, out-of-touch, old people sit around a table every couple of months and sift through stale data to decide what the cost of money should be for hundreds of millions of people and businesses -- is severely antiquated and dangerously out of date.
If our central bankers don’t immediately invest in technologies, most importantly in generative AI, to have tools that can analyze the relationships between trillions of data points per second, to help them make better decisions and predict resultant impacts in real-time, we will all be doomed to live in an increasingly out of control, boom and bust, roller coaster economy.
Believing that monetary policy can cure everything is as dumb as believing markets will solve everything.
Perhaps, the most glaring flaw in the theory the Fed operates under is the conviction that monetary policy (raising or lowering interest rates) is the best tool to deal with inflation. This assumption is false. Without coordinated “fiscal policy,” monetary policy alone is destined to fail.
Consider for a moment that the oil industry and the housing industry, together, are by far the biggest industries in the country. This is because so many other industries, services, and products are dependent on them and an integral part of their economic ecosystem -- food, plastics, cosmetics, building materials, gasoline, heating oil, and millions of other products are oil-dependent and the housing industry impacts everything from mining, forestry, and raw materials, finished products fabrication, appliances, furniture, lighting, and everything else in the world that you find at Home Depot.
But of all these things, food, energy, and shelter are the most fundamental. The price of food, gasoline, mortgage rates, and rent are where the rubber meets the road for most people. So, why not consider those separately in interest rate policy and monetary policy, so as not to throw the baby out with the bath water when trying to calm inflation?
Mortgage interest rates (for single-family and multifamily residential) could be set separately from borrowing costs (the Fed Funds Rate) to reduce the negative impacts on the housing market. Pricing of basic food products could be temporarily regulated (just as it has been done in the past during depressions and war times) to calm markets. And it is inexcusable that consumer gasoline prices have not been temporarily capped (particularly in California… Mr. Newsom, are you listening?), at the federal and state level, since the pandemic.
Done correctly, none of these measures would have significant negative, long-term impacts on companies involved but they would have a huge positive impact on inflation psychology, economic stability, and food, gasoline, and housing affordability.
So, one has to ask, why haven’t fairly obvious ideas like these been considered in recent years? They could still have a positive impact on inflation and the perception of rising inflation if enacted today.
This is a valid question.
Could this be another case of money talks and everyone else gets screwed, where big political donors and oil and finance industry lobbyists hold sway? Maybe this failure of fortitude and imagination by government “leaders” at every level is one of the reasons the general public seems so pissed off at their elected officials these days.
[1] https://www.investopedia.com/ask/answers/12/inflation-interest-rate-relationship.asp
[2] https://prospect.org/economy/2024-01-04-time-for-victory-lap/
Bob Silvestri is a long-time Mill Valley resident, the Editor of the Marin Post, and the founder and president of Community Venture Partners, a 501(c)(3) nonprofit community organization dedicated to bringing the community's voice to government decision-making and funded exclusively by individuals and nonprofit donors. Please consider donating now to support our work.