Bryan D. from Nashville, TN asks: Hello Mitch, I’m trying to settle a debate among some of my investor friends. The question is simple: were the Fed’s actions with hiking interest rates and QT the reason inflation has fallen steadily since last year? Or are other forces at work? Thanks for taking the time.
Mitch’s Response:
Thank you for sending in your question. Happy to offer my perspective on an issue – it’s a question that is pretty layered and I think largely misunderstood.
One way to address the question is to first ask how we got inflation in the first place. The answer involves supply and demand forces, but it was the supply side of the equation that delivered higher prices across the developed world.1
But let’s start with demand. In the wake of the Covid-19 pandemic, the U.S. government engaged in historic fiscal stimulus, that involved direct transfers (stimulus payments) totaling trillions of dollars across two administrations. Armed with cash and largely confined to homes, Americans shifted spending from services to goods.
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That’s where the supply problem comes into play. Inflation is a monetary phenomenon where too many dollars are chasing too few goods, and that’s what we got: excess demand was met by snarled supply chains, labor shortages due to the pandemic, rolling factory shutdowns across the world, clogged ports, and rising shipping costs, to name a few. The fiscal stimulus made matters worse, sure, but even if we removed U.S. fiscal stimulus from the equation, there still wouldn’t have been enough goods.
To fix the surge of inflation meant fixing the supply problem, but it also meant opening the door for U.S. consumers to shift spending from goods back to services. In the immediate aftermath of the pandemic, both of these objectives proved difficult to meet.
When the Fed starts hiking interest rates, it’s important to understand that higher interest rates could neither unclog supply chains nor could it encourage consumers to shift spending. As such, I would argue that a substantial portion of inflation’s decline had nothing to do with the Fed. As inflation was almost wholly a supply problem (again, too few goods), the Fed was pretty powerless to address the issue by ending QE, trimming its balance sheet, and/or raising the Fed funds rate.
To make matters more complicated, just as the global economy was ramping back up, supply chain issues were starting to resolve, and spending was shifting from goods to services, Russia invaded Ukraine. The war created major dislocations in the oil and gas markets, reducing global supply as many nations banned Russian energy imports. But the war also disrupted food supplies, fertilizer production, and further obstructed global shipping routes. Consumers around the world felt these inflationary effects, not just Americans.
Meanwhile, the Fed was raising interest rates and engaging in quantitative tightening (QT), and inflation eventually started coming down in June 2022. While it is true that interest rates were going up and inflation was coming down at the same time, I’d be hesitant to tie the two together and give the Fed credit.
One final note I’d like to make, however, is that I do believe higher-for-longer rates can help with the ‘last mile’ of inflation, as the Fed funds rate is now higher than both inflation and the 10-year U.S. Treasury bond. That indicates that monetary policy and financial conditions are tight, which can crimp banks’ incentive to lend and inhibit economic activity, and perhaps even result in layoffs and a mild recession – both of which would reduce inflationary pressures. As such, the Fed may ultimately help with the inflation issue.
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• The importance of analyzing your spending by category
• Strategies to maximize Social Security retirement benefits
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Disclosure