After more than a year of delay, the Federal Reserve finally looks like it is serious about reducing inflation. The meager 25 basis point increase in April and the 50 basis point increase in May were much too small and much too late. Look for larger and more frequent rate increases before year-end.
The best measure of inflation at the consumer level is the Consumer Price Index (CPI). The CPI has increased by 8.6% in the last 12 months. That is the highest inflation rate since 1981. Unfortunately, the CPI will increase in the coming months as energy, food and commodity prices continue to rise. Business will also see rising wage rates for their workers.
By late summer we could see the CPI approach double digits. At the same time, the economy will have stalled. Growth in the first quarter of this year was -1.5%. If that negative growth continues into the second quarter, that would mean the economy has experienced two successive quarters of negative growth in gross domestic product (GDP), which is the classic definition of a recession.
High inflation with a stagnant or shrinking economy is called stagflation. That’s a problem we haven’t seen since the late 1970s. The real problem is that getting rid of stagflation is very difficult and must be done in stages rather than at once.
That’s because to reduce inflation, demand must be removed from the economy. Using monetary policy, this is accomplished by reducing the rate of growth in the money supply and raising interest rates. This is what the Fed is doing now. However, the action to reduce demand tends to slow economic activity and make the recession worse.
To end a recession, the Fed would reverse that action and increase the rate of growth of the money supply and reduce interest rates. That would increase demand to grow the economy, but, alas, that would add to inflation.
Last year, the Fed wanted to grow the economy, so it expanded the money supply and kept interest rates near zero. That caused inflation to soar. This year, it apparently wants to reduce inflation, but as explained above, that will slow economic activity and lead to recession.
As I have noted in numerous Newsmax Finance columns in the past year, the Fed’s hesitancy to slowly raise rates last year, is what has led us to the critical junction of this policy dilemma.
As rates continue to rise significantly for the rest of this year, many consumers will complain that mortgage rates are so high, that they can no longer afford to buy a home. Actually, that is the purpose of the rate hike. Inflation is caused mostly by excess demand. As the Fed raises rates, some consumers drop out of the market for interest rate-sensitive products like houses and automobiles.
That reduction in demand will stabilize housing prices, which have generally seen prices increase by more than 15% in each of the last two years. In fact, all credit will become more expensive. That means consumers will be reluctant to use their credit cards. That, too, will reduce demand and lower inflation.
Most economists will say that even with this 75-basis-point increase, interest rates are still very low. That means more and larger increases will be needed to reduce inflation. Already, mortgage rates, which were as low as 2.5% early last year, have climbed to near 6%. By year-end, mortgage rates will likely be in the 8% range.
An Economic Mess
The economic mess we are in now is all a result of government policy. The high inflation is mostly due to the Biden administration’s restricting the supply of energy and driving up the price. It is also due to the Biden administration giving unemployed workers free money to remain unemployed. That led to wage inflation.
Additionally, Biden spent nearly $3 trillion on the American Rescue Plan and the Infrastructure bill. That created much of the excess demand. And lastly, the inflation problem was also due to the shockingly irresponsible monetary policy of the Federal Reserve last year.
This is the worst of all possible economic conditions. We have high inflation and a recession. It is not the fault of Putin and it is not OK to say we are not as bad as other countries, since the other countries essentially followed what the U.S. central bank led them to do.
The Biden administration did this because it was more concerned with curing real or perceived social injustices and overreacting to climate change rather than forming economic policy to achieve the economic goals of price stability, full employment and growth.
This is Biden’s economy.
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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