I have argued repeatedly in this blog that one of the great economic unknowns is what causes inflation and why. The classical argument is money supply expansion, which seems to work empirically for hyperinflations, but not for moderate or galloping inflation rates. Indeed, the best general equilibrium economic models we have are completely devoid of money and the methods that we employ to get money into the system (cash-in-advance [CIA} constraints, for instance) beg justification, particularly in a world where no-one carries ‘cash’ anymore. [A few years ago I asked a brilliant Stanford professor how he justifies the CIA in his policy papers and he just looked at me as if I was thinking too hard. Just the fact that the mechanism got money into the model was enough for him. I don’t know (IDK)…]
More broadly, the Federal Reserve has just hiked rates by another 0.75% bringing the short-term rate to its highest level since 2008. This is quite amazing since (i) the jury is still out as to whether inflation is a ‘thing’ now (ii) the Fed doesn’t have any idea what is causing this ‘thing’ and (iii) standard monetary aggregates are indicating no recent surge in the money supply nor the demand for money. Two things can raise prices – higher demand or lower supply. One thing can finance inflation – an accelerated money supply growth rate. It would seem that supply shortages are pressing prices higher – energy, food and shelter, pandemic residuals and labour constraints. It does not seem that money growth is accommodating/financing price rises across the board. How does an interest rate hike solve these micro-economic issues? The stated objective is to reduce demand so as to reduce price pressure but this is a very one-sided view of the world. Why not lower interest rates to increase supply-side investment and output since this seems to be the cause of the price-spike? I don’t believe this would work either but it is just as logical as the Fed’s demand-side justification.
The Fed seems to have fallen into the trap of thinking that doing something is preferred to doing nothing, no matter how little they know and how little it addresses the problem. The world has spent the last 4 decades blissfully free of activist monetary policy. The Central banks don’t know what to do so they are raising interest rates.
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