Economists say Fed plan will bring inflation down, in time
Published 4:32 pm Saturday, July 30, 2022
By Greg Goldfarb
The K-V Dispatch
As Virginians continue to bow to the pressure of record-high economic inflation, two Virginia economic scholars say that much-needed financial relief may not be right around the corner. But, it’s coming.
Consumer prices will likely continue to be higher than usual for the rest of the year and maybe beyond, while federal monetary leaders find a pathway to lowering the price of everyday commercial products.
And even though there may be hope on the horizon, for now, high prices are causing economic hardship in many households and businesses across the state.
“The worry is that inflation expectations have taken root, which could make combatting it much more difficult for the Federal Reserve Board,” said Dr. David Lehr, MBA program director and economics department chair at Longwood University. “Generally, the Fed is trying to tamp down on overall demand through interest rate hikes, but trying to do so just enough to rein in inflation without going too far and causing a recession, like what happened in the early 1980s. Inflation will come back down to previous levels, but when and with how much pain is still unknown.”
Over the past 100 years, the inflation rate in the U.S. has averaged 3.22% per year, but was as high as 18% in 1910, and has reached double digits again eight times since then, including hitting 18% in 1980.
More recently in the U.S., the Consumer Price Index rose 6.8% between November 2020 and November 2021, spurred mostly by price increases for gasoline, food and housing. Higher energy costs caused the inflation to jump further in 2022, reaching 9.1%, a high not seen since 1981. Opinion polls say it’s the main topic on many people’s minds.
The high inflation being experienced now is different from that of the past, not just because of the increased dependency countries from around the world have on each other to meet their needs, but because it is also being affected by increased consumer consumption.
“Inflation started to take hold in early 2021, primarily driven by an imbalance between overall supply and demand in our economy,” Lehr said. “COVID-related issues curtailed supply while federal stimulus response to COVID, combined with pent up household savings, led to rising demand. Although gas prices have come down, it is too early to tell when overall inflation will reach more normal levels. The inflation experienced in the early 1980s was similar to what we are seeing today.
“It is not unusual to see inflation pressures mounting when unemployment is low,” Lehr added. “Typically, there is a trade-off in the short run between good inflation numbers and good unemployment numbers.”
Even though the national unemployment is a little over 3%, the country could fall into a recession, triggered by people holding onto their money during tight times, and also trying to make the most of it.
“Goldman Sacs economists give the odds of a recession at 50/50,” Lehr said. “That is about where I’d put it; all depends on how good, or lucky, the Fed is at creating a soft landing, along with all the geopolitical/health global issues.”
In the United States, the Fed regulates the federal funds rate, which is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis, according to online data. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions’ reserve requirements.
The Federal Reserve recently raised interest rates by three-quarters of a percentage point, the most aggressive hike since 1994, according to online data. This rise puts the key benchmark federal funds rate at a range between 1.5% and 1.75%. The Fed also discourages consumers from making large purchases and wants people to pull back on spending. The goal is to lower demand over time, allowing prices to come down and stabilize. This power to set interest rates is one of the Fed’s main tools to steer the nation’s economy.
With so much economic control being exerted at the national level, there’s not much action local governments can take to battle economic inflation.
“Local and state governments cannot do anything, except perhaps make it a bit worse,” Lehr said. “A gas tax holiday, for example, is a terrible idea; refineries are limited and at capacity right now and a gas tax holiday will just drive up demand, leading to higher gas prices that will offset the tax cut. The Federal Reserve is the primary policy-maker we have to fight inflation. Fiscal policy can do little on the supply side. (We should be) doing what we can to have ‘demand growth’ match, but not exceed, ‘supply growth’ in our economy.”
Matthew Todd “Matt” Holt, professor and head of the Department of Agricultural and Applied Economics, Virginia Polytechnic Institute and State University, relates the country’s high inflation rate to international affairs.
“There is not one primary cause,” he said. “It is linked to the war in Ukraine, which has caused massive disruptions in global food and energy supplies and markets. Russia is a major supplier of energy, especially to Western Europe. And while western sanctions against Russia are an appropriate response, the impact on global energy markets has been real and significant.
“Supply chain disruptions resulting from the COVID pandemic continue to be a factor, especially the tight zero-tolerance lockdown policies that China has continued to enforce,” Holt said. “Supplies of both finished consumer goods and key manufacturing components continue to be impacted by supply chain snarls. There is also the impact of the stimulus packages the federal government offered in both 2020 and 2021. As important as the stimulus packages were at the time for stabilizing the economy during the pandemic, we are suffering some of the proverbial hangover now.”
Economies do not remain the same indefinitely, because there are so many internal and external forces interacting with them. Financial markets seek stability to prosper and need to have a clear picture of what lies ahead.
“Nobody can know for sure what a ‘new normal’ might be regarding inflation,” Holt said. “But, Federal Reserve Chairman Jerome Powell has made it clear that ‘job one’ for the Federal Reserve is fighting inflation; he wants it to be stabilized around 2%, or the expected growth rate in GDP. I believe him. I suspect the Fed is even willing to risk tipping the economy into a recession to combat the corrosive effects of inflation. The current inflation picture will likely not remain for long.”
Economists are pleased that the national unemployment is low, said Holt, but it could lead to some adverse results.
“It is rare to observe high inflation and low unemployment at the same time,” he said. “And these are situations that tend not to last for long. And they tend to end with a recession. Low unemployment will not prevent a recession by itself. Higher wages and employment do help ‘break the fall’ of inflation, but even with recent wage growth in the 5% range, with inflation at or above 8%, people are still worse off in terms of purchasing power.”
Times may be tough now, but based on historical precedents, all is not lost.
“We are never helpless,” Holt said. “A combination of smart, timely policies and actions can always help mitigate, although not eliminate, major economic risks. We have been in bad economic straits many times in the past and have come through them.”