Can The Federal Reserve’s New Plan Beat Inflation?

Federal Reserve Chair Jerome Powell Holds News Conference On Interest Rates (Photo by Alex … [+] Wong/Getty Images)

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The U.S. economy is in an inflation-friendly environment. The Federal Reserve’s easy money policies and the U.S. government’s borrowing/spending activities have helped inflation to begin rising.

So, can the Federal Reserve’s new interest rate-raising plan control inflation’s rise? While the Fed plans for multiple increases, its new “higher” current rate range of 0.25%-0.5% is still in very low, easy money territory. A market-determined interest rate would be tied to the inflation rate outlook, so it would likely be at least 4% now. Moreover, it would probably take an even higher rate to tamp down inflation.

Another inflation catalyst awaits: Bank lending

Most inflationary periods have banks fully participating. However, they currently remain an underused money resource. JP Morgan Chase CEO Jamie Dimon, on his last earnings call, talked about the huge resources the bank is holding until demand and interest rates increase.

When banks lend, they create money (demand deposits), thereby increasing the money supply (and spending), just like the Fed. Therefore, they can spur inflation upwards as well.

If inflation is not controlled now, expect these actions

As inflation worms its way through the economy and financial system, the search for “painless” (AKA non-recession) cures will return. Price controls, rationing, special taxes on resource companies, forced conservation, deregulation, undermining union contracts, underfunding government agencies, reducing maintenance, altering work hours, limiting pay raises (below the inflation rate), etc. Contract COLAs (cost of living allowances) will keep negotiators and lawyers busy.

The two graphs below show what happened when inflation was not constrained previously: first, the entire period of 1960 to today; second, the culmination and cure period of 1978 to 1983.

1960 to current inflation and interest rates

John Tobey (FRB of St Louis – FRED)

The extended time and pain required to reverse runaway inflation (1978-1983)

John Tobey (FRB of St Louis – FRED)

The bottom line: What goes around, comes around

Capitalism works through market-based determinations, especially for interest rates. However, to ensure fair and effective results, regulations are required. Moreover, there are times when the financial system has problems and needs help. That’s where the Federal Reserve steps in. Unfortunately, economists, like many professionals (and observers), can begin to believe they know better than the markets. A good, relevant quote is the following:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

John Maynard Keynes