Taming Inflation? Consider the Tradeoffs
March 18, 2022
Central bankers face some difficult choices when deciding how to wrangle rising costs.
For the past four decades, Americans have enjoyed consistent inflation that has hovered near the Federal Reserve’s target of 2%. Now a combination of factors is upsetting the status quo.
In February, the key U.S. inflation measure, the Consumer Price Index (“CPI”), showed that prices for goods and services rose 7.9% compared to a year ago, the highest level since January 1982. On a monthly basis, prices for food, clothing, shelter, fuel, and other essentials that make up the CPI “basket” increased by 0.8%, higher than the expectations of many economists.
Faced with inflation at a 40-year high and roiling energy and financial markets because of the war in Ukraine, U.S. policymakers are debating how best to respond and balance the need to tame inflation without suppressing post-pandemic recovery.
It is a delicate dance; the usual levers for controlling inflation, such as the Federal Reserve adjusting the benchmark lending rate (more about that below), come with tradeoffs that risk cooling the recovery.
The tradeoffs have stirred much debate among policymakers, academicians, business leaders, and even the public about the best way to respond.
What Is Driving Inflation, Anyway?
Inflation is driven by many factors. The genesis of our current inflation is the start of the pandemic in March 2020, with three major factors playing a role.
First, factories shutting down due to the pandemic disrupted supply chains, hence businesses could no longer acquire the components and materials they needed, such as microchips, to produce the merchandise consumers wanted. Second, those retaining jobs altered their behavior and withheld spending. Third, federal stimulus measures pumped more money into savings.
And boom! When consumers threw open their wallets in 2021, demand soared, causing too many dollars to chase after too few goods and services, provoking inflation. Additional factors were at play, including labor shortages and other temporary supply chain disruptions — all of which add to the complex inflation puzzle policymakers now face.
The “Catch-22” of Counter-Inflation Measures
Policymakers are typically concerned with three issues when it comes to inflation. Rising prices is one, of course. The others are employment and interest rates.
Taken together, the three issues are in the scope of the Federal Reserve (the “Fed”) and monetary policy. All three require scrutiny and interact with the federal debt. Here’s why:
Interest Rates: While the Fed cannot directly lower prices, it can, as noted earlier, raise the benchmark borrowing rate. In fact, it did just that on March 16 of this year when it announced an increase of a quarter percentage point — the first such increase since 2018. A higher benchmark rate incentivizes savings at the expense of spending and leads to higher interest rates on everything from consumer loans — like mortgages, auto loans, and credit cards — to business loans intended for starting new businesses or expanding existing ones.
As credit becomes more expensive, the economy “cools” with a dampening of demand. Fewer dollars chase available goods and services, thereby alleviating inflation.
Employment Levels: When it comes to higher interest rates and a dampening of demand, policymakers weigh serious real-world consequences for individuals and businesses. Purchases and investments that made sense at low interest rates might no longer make sense at higher interest rates. Tighter credit weakens consumer demand and investment, slowing economic growth.
Federal Debt: Like all borrowed money, the federal government’s debt is sensitive to interest rates. According to the Congressional Budget Office (“CBO”), federal debt held by the public in the form of bonds reached $21 trillion in 20211. Net interest payments were $331 billion, nearly the gross domestic product (“GDP”) of the state of Missouri ($366 billion).
The average remaining maturity of the federal debt is 5.5 years. This means that approximately 18% of the federal debt is refinanced every year. Higher interest rates might tame inflation, but they would risk the economic recovery and degrade the fiscal position of the federal government by increasing interest costs2.
Following the March 16 announcement, the Fed is scheduled to meet six more times this year to discuss further increases in the benchmark borrowing rate.
How Policymakers Can Tame Inflation Outside of Interest Rates
Increasing interest rates is the classic response to tame inflation, but it comes with its costs. Here are three options for addressing inflation that might have other benefits:
Energy Sector: Addressing rising energy prices, a significant cause of supply-side inflation, has become a more pressing concern for policymakers, particularly given the major potential disruption to energy exports from Russia. Multiple issues are at work here. First, energy prices affect suppliers directly in the commodities they purchase, such as diesel fuel and electricity, and indirectly through energy-intensive sectors, such as steel, which must pay more for their inputs. Second, electricity prices strongly correlate with natural gas prices, which are seeing their highest persistent levels since the Great Recession.
The United States could expand domestic production of natural gas and petroleum to put downward pressure on energy prices. It could also encourage more renewables, such as wind and solar, which can help to reduce electricity prices. Additional supporting infrastructure (e.g., pipelines or transmission lines to move wind and solar power to urban centers) could also help against inflation.
Technology: Advances such as predictive analytics could improve supply chain resiliency and visibility. Whether it is forecasting worker shortages or improving networks and sourcing agreements, businesses have reason to innovate to minimize future disruptions. Policymakers could help incentivize these developments through tax credits or strategic workforce investments.
Immigration: Low unemployment during a recovery (signifying a labor shortage) could slow the economy. Policymakers could allow for more immigration to fill gaps between labor supply and labor demand, especially in fields developing new technology or building infrastructure.
While there are no easy “fixes” to inflation, policymakers have a variety of methods from which to choose. Whatever direction they decide to go, whichever levers they pull, there will be tradeoffs — and understanding these is crucial for individuals and businesses.
2: An example of such risk would be requiring higher taxes or spending cuts to combat compounding interest on the debt.
© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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