The ninth consecutive rate hike is meant to discourage inflation by increasing the cost of borrowing, which can slow the economy and possibly trigger a recession. In turn, it increases the growing cost of credit cards, auto financing and other loans.
With the move, the central bank has increased the federal funds rate from nearly zero in March 2022 to a range of 4.75% to 5%.
There was some speculation that the Fed might pause rate hikes in response to recent banking failures, including Silicon Valley Bank. However, Federal Reserve Chair Jerome Powell has repeatedly said that price stability is the central bank’s main focus. However, may this Fed’s policy influence the worst case scenario of stagflation? Let’s find out.
What Is Stagflation?
Stagflation is an economic cycle characterized by slow economic growth (a recession), high unemployment rate and high inflation. Economic policymakers find this combination particularly difficult to handle, as attempting to correct one of the factors can influence another.
Stagflation can be caused by a variety of factors, including:
- Supply shocks: A sudden disruption to the supply of key resources or commodities can cause prices to rise, which can lead to inflation even as economic growth slows.
- Government policies: Poorly designed government policies, such as overly expansionary monetary or fiscal policies, can cause inflation even as the broader economy struggles.
- Structural problems: Structural problems in the economy, such as labor market rigidities or inefficiencies in the distribution of goods and services, can lead to high unemployment even as prices rise.
Stagflation is generally considered to be a challenging economic environment for policymakers, as it can be difficult to address both high inflation and high unemployment simultaneously. Some of the tools that are typically used to address inflation, such as raising interest rates or cutting government spending, can exacerbate unemployment, while policies aimed at reducing unemployment, such as expansionary monetary or fiscal policy, can fuel inflation.
In mid-2022, many were saying that the United States had not entered a period of stagflation, but might soon experience one, at least for a short period. In June 2022, Forbes magazine argued that a period of stagflation was likely because economic policymakers would tackle unemployment first, leaving inflation to be dealt with later.
The year-of-year over rate of inflation has slowed to 6%, but it’s still above the Fed’s preferred rate of 2%. And it seems that Fed is not doing a very good job handling the inflation as we already see large banks as Silicon Valley bank and Credit Suisse failing.
Rate hikes are often referred to as a “blunt instrument” because they affect the entire financial system. The effects are very hard to measure, since it can take many months for a rate hike to be fully absorbed by the economy.
Since each rate hike adds to the risk of a recession, the Fed has slowed its increases somewhat, opting for 25 basis point hikes in February and March instead of the 75 basis point increases it enacted in late 2022. Despite the Fed slowing its roll, Powell has repeatedly said inflation remains a top priority.
Why Is Stagflation Bad?
As I said Stagflation is a combination of three negatives: slower economic growth, higher unemployment, and higher prices.
This is a combination that isn’t supposed to occur, in the logic of economics. Prices shouldn’t go up when people have less money to spend.
Here are a few reasons why stagflation is generally viewed as a negative phenomenon:
- Reduced purchasing power: High inflation erodes the purchasing power of individuals, as prices for goods and services rise faster than wages or incomes. This can lead to a reduction in the standard of living for many people.
- Unemployment: Stagflation is characterized by high unemployment, which can lead to reduced incomes, lower consumer confidence, and a slower economy overall.
- Reduced investment: With a stagnant economy, there is often less investment in new businesses or projects, as investors may be hesitant to take on risk in such an environment.
- Policy challenges: Stagflation can be particularly challenging for policymakers, as the typical solutions for addressing inflation or economic stagnation may exacerbate the other problem. This can lead to difficult choices and trade-offs for policymakers.
- Social unrest: High inflation and high unemployment can also lead to social unrest and political instability, as people become frustrated with their economic situations and may demand change.
Overall, stagflation is seen as a negative economic situation that can have broad impacts on individuals, businesses, and society as a whole.
What is the cure for stagflation?
There is no definitive cure for stagflation. The consensus among economists is that productivity has to be increased to the point where it will lead to higher growth without additional inflation. This would then allow for the tightening of monetary policy to rein in the inflation component of stagflation.
The cure for stagflation depends on the underlying causes of the problem. However, some potential solutions that have been used in the past or suggested by economists include:
- Tight monetary policy: Raising interest rates or reducing the money supply can help to control inflation, although this can also lead to higher unemployment and slower economic growth.
- Fiscal policy: Governments can use fiscal policy tools, such as reducing government spending or raising taxes, to reduce demand and control inflation. However, this can also lead to slower economic growth and higher unemployment.
- Structural reforms: Addressing structural problems in the economy, such as labor market rigidities or inefficient distribution of goods and services, can help to reduce unemployment and improve economic growth over the long term.
- Supply-side policies: Policies aimed at increasing the supply of goods and services, such as deregulation or investment in infrastructure, can help to reduce prices and ease inflationary pressures while also stimulating economic growth.
- Wage and price controls: Governments can implement wage and price controls to try to limit inflation, although this approach has been criticized for being ineffective and causing unintended consequences.
It’s worth noting that there is no easy or guaranteed cure for stagflation, and policymakers must carefully balance the need to address both inflation and economic growth. Additionally, the appropriate mix of policy tools may vary depending on the specific circumstances of the economy in question.
That is easier said than done, so the key to preventing stagflation is for economic policymakers to be extremely proactive in avoiding it in the first place.
However, once Covid hit, a lot of people started working from home and as we all know working from home is not as productive as employees operating from office usually get more done. That’s one of the reasons why inflation rose to such highs as a lot of people were working from home during Covid and maybe this will be the solution for future stagflation – for everybody to go back to office, as this will increase productivity.
