Tags: federal reserve | inflation | consumer demand

Fed's Pause Contributes to Harmful Inflation Psychology

Fed's Pause Contributes to Harmful Inflation Psychology
(Dreamstime)

By    |   Monday, 25 September 2023 10:36 AM EDT

Once again, the Fed has eased up on its restrictive monetary policy too soon. Late last year the Fed stopped its 75-basis point interest rate increases. Now they stopped all increases. That will contribute to the excess demand and will lead to higher inflation rates. Worse, it is contributing to an inflation psychology that may soon grip the nation.

Inflation psychology comes when Americans believe that outrageous price and wage increases are normal and, worse yet, acceptable. Once that happens it allows inflation to become embedded in the economy. And it is very difficult to eliminate.

As noted in prior columns, the inflation that we have experienced since January 2021, is almost entirely a result of excess demand. In the last four fiscal years the federal government has deficit spent $9 trillion. On a $24 trillion economy, that is pure excess demand.

At the same time, the Federal Reserve pursued a shockingly irresponsible monetary policy. With the economy growing at a 6% rate in 2021 and with the massive government deficit spending, the Fed kept interest rates near zero through the entire year and all the way to June 2022.

Worse yet, the Biden administration was deficit spending about $250 billion monthly. To help ensure short-term market stability, the Fed purchased $240 billion per month of that debt by simply electronically printing money. That massive increase in the money supply leads to pure excess demand.

Finally in June 2022, the Fed realized that price stability is a goal of the Federal Reserve’s monetary policy. That’s a realization they apparently ignored from January 2021 to June 2022.

Because inflation had skyrocketed to a 9% annual rate, dramatic action was needed. At the time, I believed that the Federal Funds Rate must hit at least 6% to get rid of the inflation problem. I am sticking to that number today. And the longer it takes to get there, the more inflation becomes embedded in the economy.

Had the Fed not eased up on the 75-basis point rate hike for another month or so, the Fed Funds Rate would be at 6% today and inflation would be tamer.

I always note, as Ronald Reagan said, that inflation is a cancer that must be treated early and aggressively. Because the federal government did not act in 2021, inflation is entering into consumers and workers thinking and creating inflation psychology.

Now consumers and workers are becoming less rational when paying prices and when seeking wage increases.

Normal behavior for a rational consumer is to resist a price increase on any product. In other words, suppose a consumer, prior to the start of this inflation, found a good “everyday” bottle of red wine. The wine was priced right at $10 and tasted great.

For many years the consumer purchased the wine. Then one day, they go to buy it and the price is $12 per bottle. A rational consumer usually thinks that the wine was a great value at $10 but questions the value at $12. Usually before the next wine purchase, the consumer would see what options were available. The wine may still be purchased but there may be a lot of good wines selling for less than $12.

The point is that the consumer will generally resist a price increase.

Once the inflation psychology becomes embedded, consumers take a different view when confronted with a price increase. They believe that “all prices are going up” and that “they had better purchase it now, because the price may be higher tomorrow.” That inflation psychology leads to increased demand and higher prices.

It is just as irrational with large wage demands. For almost two decades prior to 2021, inflation generally was in the 2% to 3% range, ending 2020 at less than 2%. During that period most people saw wage increases in the 3% to 4% range, so there were real wage increases.

A 3% to 4% wage increase became the norm. Anything much above that seemed outrageous.

Once inflation psychology becomes embedded, workers see that inflation hit 9% and that could happen again. Because inflation inflated corporate profits workers believe that they deserve a 9% wage increase and more.

In normal times everyone scoffs at such a ridiculous demand. But with inflation psychology, the public accepts it.

At the same time an inflation psychology grips the country, a wage/price spiral forms, which makes inflation even more difficult to end.

At this point the Fed must get more aggressive with interest rate increases, and the federal government must cut its spending, even if that slows the economy.

Inflation is a cancer and must be treated early and aggressively.


________________
Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.

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MichaelBusler
Once again, the Fed has eased up on its restrictive monetary policy too soon. Late last year the Fed stopped its 75-basis point interest rate increases. Now they stopped all increases. That will contribute to the excess demand and will lead to higher inflation rates.
federal reserve, inflation, consumer demand
818
2023-36-25
Monday, 25 September 2023 10:36 AM
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