The Fed battles record-high inflation by raising interest rates... again

The United States Federal Reserve (the Fed) announced its sixth consecutive increase to interest rates last week, the latest effort to control record-level inflation gripping the country. The fourth consecutive increase this year of 0.75 percentage points places the overall interest rate between 3.75 and 4 percent. Inflation has been a major topic for politicians and the media since last year, as the economic impact on Americans harshened in the run up to the midterm elections.

According to the Consumer Price Index, inflation peaked in June at 9.1 percent, the highest level in 40 years, before dropping down to 8.5 in July. So far, inflation has continued to decline. As of October, the year-over-year rate is 7.7 percent. However, core inflation, which excludes volatile food and energy costs, reached a 40-year peak in September, as prices increased 6.6 percent from last year, a 0.6 percent increase over the previous month. But that also appears to have decreased to 6.3 percent in October. Regardless, the October data inspired hope that inflation may be cooling, leading to the market’s single biggest positive response since 2020.

This is good news for Democrats, who received vindication in the midterm election when Republicans failed to mount a successful campaign against them over inflation. Yet, election-day exit polls show that inflation remains a pressing issue for Americans. President Joe Biden and the Fed previously dismissed signs of inflation as “transitory” but changed tact after inflation proved to be persistent. The Fed has since embarked on the most aggressive tightening campaign since the Volcker Shock of the 1980s.

A Flawed Approach?
The Federal Reserve, the United State’s central bank system, is the chief monetary institution in the country and regulates the financial system to maintain a healthy economy. In 1978, Congress gave the Fed a dual mandate: maintaining “price stability” and achieving “full employment.” They do this by adjusting interest rates and buying and selling, namely, U.S. Treasury bonds. At the beginning of the pandemic, amidst Covid-related shortages that threatened a recession, the Fed slashed interest rates to zero and went on a bond-buying spree, injecting money into the economy. Coupled with legislated direct relief to people and businesses, this stimulus kept the economy afloat. But the Fed reversed course in March as inflated consumer costs grew overtly evident.

The Fed has aggressively employed its main tool against inflation: interest rates. The Fed intends to control inflation through a practice known as ‘demand destruction.’ The idea is that in a booming economy, people have more money to spend which drives up demand, and if supply cannot increase to accommodate, prices are pushed higher. By raising the federal funds rate, the Fed can broadly influence the cost of borrowing on mortgages, car loans, credit cards, and business loans. Raising borrowing costs redirects surplus money towards servicing debt. Consumers spend less on goods and services, and businesses stop investing and start downsizing which in turn curbs — or destroys — demand. But the Fed’s approach has come under question as critics argue higher interest rates threaten a recession and will not resolve the core issues beneath inflation.

Many economists argue that inflation is not entirely demand-driven but also supply-sided. Currently, pandemic-related disruptions in the global supply chain are a primary driver of inflation. The Russian invasion of Ukraine has exacerbated these existing supply chain issues, creating serious shortages in food and energy sectors. Russia, the world’s third largest oil producer, accounts for a tenth of global oil supplies. Likewise, Ukraine and Russia contribute nearly 20 percent of global cereals trade. Sanctions imposed against Russia drove up gas prices and energy costs. Ukrainian exports are similarly diminished by a Russian blockade on Ukrainian ports and lowered agricultural production from the war, creating a global food shortage. On the other side of the equation, changes in consumer spending habits during the pandemic — a shift away from services and towards more goods — worsened price conditions by raising demand on already limited supply.

Unfortunately, increased interest rates cannot fix supply chain infrastructure, leaving inflation’s long-term causes unresolved. Federal Reserve Chair Jerome H. Powell acknowledged the Fed’s rate hikes cannot address the food and energy crisis so pivotal to ongoing inflation. Worse, David Daden for the “American Prospect” warned that discouraging investment might leave businesses unable to solve supply chain issues, prolonging or multiplying inflation woes.

Look, for instance, at the housing market. It became a major inflation source as house prices surged during the pandemic under historically low mortgage rates. A Federal Reserve Bank of San Francisco report concluded that white-collar jobs shifting to work-from-home contributed considerably to increased prices. Similarly, Fortune revealed that investors — from minor landlords to large private equity firms — buying properties contributed significantly to increased housing costs. Raised demand coupled with already-low housing stock created the housing bubble. The Fed targeted this demand by raising mortgages.

As of Nov. 10, 30-year fixed mortgage rates reached a 20-year high of seven percent, exceeding rates during the 2008 housing crisis. Housing prices fell accordingly, but while the Fed has lowered demand, it also has not. According to Skanda Amarnath at Employ America, “The housing demand that the Fed directly cools is investment demand, not consumption demand.” The demand for housing remains — people need a home to live, after all — while supply continues to remain low. But the Fed’s rate hike discourages developers from investing in new housing, which homebuilding data appears to confirm. Pushing people away from mortgages pushes them into the rental market, choking limited rental supply and thereby driving up rental prices.

It remains to be seen whether early signs of a cooling housing market bode well for the economy-at-large, or whether the Fed’s interest rate hikes can sufficiently reduce overall inflation amid supply constraints. But on the demand side, fierce debate has focused on the labor market’s victimization under Federal Reserve policy.

‘Get Wages Down’
From the onset, the Federal Reserve has pointed to the tightened labor market as a necessary target of anti-inflationary policy. Under the Fed’s demand-driven outlook on inflation, low unemployment increases worker leverage, driving up wages and then prices as companies offload higher labor costs. To curb demand, the Fed encourages corporate downsizing (i.e. layoffs) to heighten unemployment and lower wages.

Chief Powell affirmed that the Fed’s goal is to “get wages down” and that controlling inflation will likely result in “some softening of labor market conditions.” More explicitly, Federal Reserve Bank of Boston president Susan Collins said fixing inflation will “require slower employment growth and a somewhat higher unemployment rate.”

But the Fed’s approach runs counter to evidence suggesting wages are not significantly influencing inflation. Instead, "real wages" — inflation-adjusted wages — are lagging behind inflation for many, meaning workers are losing many of their pandemic-era wage gains to higher costs. This conforms to historic trends indicating wages have not impacted inflation for years; inflation grows annually while wages stagnate. A real estate CEO poured fuel on this fire in August by saying inflation could be good for industry if it “put employers back in the driver’s seat.” The admission strengthens criticisms that the Fed and corporations are disciplining labor by lowering bargaining power amid historic wins for the labor movement.

In September, the Fed forecasted an increase in unemployment from 3.7 to 4.4 percent — meaning an additional 1.2 million people unemployed. But others estimate far less optimistic numbers regarding the Fed’s aggressive policies. BlackRock, the world’s largest investment manager, calculates quashing inflation would require three million more unemployed. The International Monetary Fund concluded it would require unemployment levels of 7.5 percent — a doubling of the existing rate and six million more without work. The Fed’s most direct impact will likely be millions more unemployed and workers broadly facing lower wages and worse working conditions.

Doubly concerning are the odds the Fed’s aggressive raising of interest rates will trigger a recession. The Federal Reserve has previously assured it can control inflation without triggering a recession, achieving what it calls a "soft landing." But others are skeptical and have pointed out soft landings are rarely achieved. Powell himself has admitted the path to a soft landing has “narrowed” meanwhile Bloomberg has raised the likelihood of a recession to 60 percent. Given the stakes, many are again warning that the Fed’s approach risks eradicating pandemic gains while leaving inflation largely unresolved — possibly worsening the situation.

But the labor market exceeded the Fed’s expectations in a new report, proving to be rather resilient. ZipRecruiter’s chief economist Julia Pollak attributed this to consumer resilience — so long as consumer demand remains high, companies will continue to hire. Although labor market conditions softened, the data likely delays any slowdown from the Fed. But many, including Democrats in Congress, are pressuring the Fed to ease up, lest they force prices down at workers’ expense.
Alongside the labor debate, critics are directing attention towards a less examined facet of the inflation crisis opposite of workers: corporations.

Record Inflation, Record Profits
Record-level inflation alongside the highest profits for corporations in 70 years has elicited accusations of corporate profiteering. The New York Times reports that food and restaurant costs have increased 13 and 8.5 percent, respectively, since a year ago while companies such as PepsiCo, Coca-Cola, and Chipotle are reporting increasingly higher profit margins on quarterly earnings. Likewise, ExxonMobil and Chevron have recently reported a fourth consecutive quarter of strong profits despite the war driving up prices. Besides food and gas, profit increases are occurring across multiple sectors — the S&P 500 gained eight percent last month after quarterly reports.

As University of Massachusetts Amherst Professor Isabelle Weber explained on NPR: “Everybody has some sort of an understanding that, oh, yeah, there are issues, so, yes, of course companies are increasing prices in ways in which they could not justify in normal times … what we have seen is that profits are skyrocketing, which means that companies have increased prices by more than cost.” She says rising profits suggest that companies capitalize on higher demand when consumers have more money to increase the amount going to shareholders.

Democrats have seized on this messaging, accusing corporations of price gouging and driving inflation. The White House has confined attacks to certain industries. Late last year, the White House blamed increased grocery prices on meat processing companies. More recently, Biden accused oil companies of "war profiteering" and threatened a windfall tax if they did not reinvest their profits into production, rather than stocks.
Some economists pushed back, arguing that supply and demand, not corporate greed, motivated price increases. These economists argue corporate consolidation does not account for inflation since consolidation has existed for years while inflation is recent. They instead point to increased demand: companies are selling more goods and services. Consumers are also willing to spend more. Larry Summers, a former Obama advisor, called profiteering claims “business bashing.”

Proponents of price gouging argue pandemic-driven inflation allows big companies to raise prices past the point of recouping increased costs. According to Josh Belvins at the Economic Policy Institute, “Evidence from the past 40 years suggests strongly that profit margins should shrink and the share of corporate sector income going to labor compensation (or the labor share of income) should rise as unemployment falls and the economy heats up.” Instead, over half of the price increase since the pandemic comes from larger profit margins, with labor costs accounting for only 8 percent. From 1979 to 2019, labor accounted for 60 percent of price growth while profits accounted for 11 percent. To Belvins, this data shows that “a chronic excess of corporate power has built up over a long period of time, and it manifested in the current recovery as an inflationary surge in prices rather than successful wage suppression.”

Critics of profiteering claims must contend with evidence that attributes soaring corporate profits to ‘pricing strategies’ and inflation. A Guardian analysis of 100 top U.S. companies revealed profits increased an average of 49 percent, with one company reporting quarterly growth over 111,000 percent. The report shows some companies — such as two of the nation’s largest home builders, PulteGroup and Lennar — increased prices by throttling production and constricting supply. Another investigation of earning calls and corporate profits by the progressive organization Groundwork Collaborative says corporate pricing power has influenced inflation.

The Democratic-controlled House passed a bill authorizing the Federal Trade Commission to punish companies engaged in price gouging, although it will likely fail in the Senate. Similarly, the Inflation Reduction Act imposed a new tax on stock buybacks, but companies may already have found a loophole.

The highest-earners are disproportionately stoking inflation while the most marginalized are disproportionately suffering its effects. Assets grew considerably under the Fed’s pandemic-era monetary policy, giving wealthy Americans more money to spend — what Edward Pinto calls the "wealth effect" driving inflation. And while the wealthy spend more, those most affected by inflation — the poorest — buy less but pay more.

The outsized role of the rich — from corporate profits to the wealth effect — has boosted demands for a reconsideration of the Fed’s priorities away from average workers and towards the wealthy. On Twitter, Former Fed economist Claudia Sahm said, “Newsflash rich people spend more money than poor people. Instead of bitching at low-wage workers for getting raises and new jobs, how about you wag a finger at the well off and their spending?”
For the most part, the future remains uncertain. Although some early signs suggest a cool down, it remains unclear whether these effects will permeate into the wider economy. Otherwise, consumers still appear strong and inflation remains high. How the Fed will respond remains unclear but it seems unlikely they will take a less aggressive approach so long as demand performs above their expectations.