Could We Rely on Inflation to Defeat the Inflation Nightmare This Time?

Some thoughts on slaying the inflation dragon.

Unless you live in an extremely remote location, you are aware of the level of inflation currently attacking this country and the rest of the world. The reasons for this inflation are many and varied depending on which commentator you are listening to.

Gas prices and groceries are the more newsworthy items suffering from the inflation infestation (and hasn’t the media had a field day with those?). The effect of these inflationary pressures is widespread and appears to be increasing.

Even the humble instant noodle, the staple food of struggling college students (and aspiring writers), is caught in the inflation net.

What is causing this inflation?

We all understand that when there is an imbalance between supply and demand, there will be a corresponding effect on the price of goods and services in an economy.

Currently, there is a worldwide level of high demand and constrained supply. This imbalance has the effect of increasing the price of the available goods and services, hence inflation.

Factors affecting supply are

• Hangover effects from the pandemic caused by labour shortages and business closures (a non-fun way to get a hangover!)
• An increasing incidence of natural disasters around the world disrupting production and transport (is climate change real?)
• The Russian invasion of Ukraine has caused surprising shortages of energy and wheat particularly (is Putin a megalomaniac?) and
• China’s zero COVID stance causing the closure of many factories which supply critical components for other manufacturers (14 cases per day is too many?)

Unfortunately, there is little that governments can do to offset these factors so it is safe to assume that the supply problems will persist for a few years.

Therefore, reducing demand to the level of available supply appears to be the only viable solution to the current inflation problem.

Reducing demand

Central banks worldwide follow the standard practice in times of inflation by increasing interest rates. The Fed has been quite aggressive, and forward estimates are that there are significant increases to come.

Other central banks around the world have been more or less aggressive in line with the economic conditions in particular countries. Even the Swiss central bank has increased interest rates by .50%, the first move up since September 2007.

But is it necessary to increase interest rates and risk pushing the economy into a recession? A recession is a real possibility for this country and many others.

After all, isn’t an increase in interest rates merely inflation of the price of money? Does adding inflation to inflation make sense?

Is this necessary?

Increasing interest rates is the standard device to reduce demand for consumption in the general population. The logic is that increased interest rates will reduce the spending by households as the long-suffering population directs more of their available funds to higher mortgage payments.

It also gives all the doomsayers an opportunity to predict “the end of life as we know it”! That does have a positive side as these “predictions” have the effect of reducing demand even further.

The exception will be those whose perverse logic leads them to believe that guns and survival kits are the solutions to their current woes. The demand for guns and the profits of gun suppliers surged in 2021.

Of course, businesses with debt will also be facing higher interest costs. They will seek to recover those increased costs by, you guessed it, increasing the price of the goods and services they supply.

If the aim is to reduce demand, could we not just rely on core inflation to reduce demand.

Can anyone honestly say that they have not actively considered ways to reduce fuel consumption? Carpooling, working from home, public transport and walking are all options we can consider to reduce our demand for gas.

The inflated price of gas has the automatic effect of reducing demand for gas which (I thought) was the aim.

The obvious exceptions to the above are the owners of electric vehicles who can safely ignore the high fuel prices. For the same reason, we can expect an increase in demand for (and probably the price of) electric vehicles.

The principle of allowing inflation to naturally reduce demand can be applied to any goods and services being supplied at inflated prices. I know I have reduced my consumption of instant noodles.

Admittedly, the effect on inflation may not be as dramatic as a 3% increase in interest rates over six months but the result would be more gradual and have less risk of recession.

And, if you read the fine print, the Fed is expecting this action to increase unemployment which is a natural result of a contraction of economic growth. Good news for those in precarious employment situations? I think not.

So, who benefits from increased interest rates?

It’s certainly not borrowers. They are the target of increasing interest rates. Home loans, credit cards and personal loans are all more expensive because the official rate increases.

The only upside for borrowers is that, in a time of high inflation, the dollars that the borrower uses to repay the debt have less purchasing power than the dollars that they borrowed. Small comfort considering the interest they pay in the meantime!

It’s certainly not consumers. They are already suffering higher prices. Add to that the increased interest cost for suppliers which they pass on in increased prices.

It’s certainly not investors. The fall in the value of equities because of the interest rate increases coupled with the increased cost of operating for companies with debt means that stock market returns will be lower.

What about those who have their hard-earned savings deposited in a financial institution? They will love an increase in interest rates, but unfortunately, the rise in deposit rates is rarely the same as the official increase announced by the Fed. For some reason, the increase in deposit interest rates is often less than the official increase.

And, speaking of financial institutions, do they benefit? Hell yes!

As interest rates rise, the opportunity for an increased margin between the cost of funds and the interest rate charged to borrowers will increase. Financial institutions have allegedly been doing it tough over the last few years while rates have been so low (look at their profit reports). But now they will be able to make some real money.

That’s interesting. The actions of the Central Bank (the banker’s bank as it is known in many quarters) mean that financial institutions increase their profits. Hmmm.

And in the same articles discussing projected interest rate rises, commentators and traders are already expecting the Fed to decrease interest rates as early as late 2023. So, the solution to the inflation problem is apparently a significant rate increase followed by an “oops, we went too far (again)” decrease.

Does anyone remember the last interest rate rise just before the pandemic? Those changes pushed the economy down the path to recession before COVID finished the job. Another example of steady guidance of the economy. Remember: when you are a hammer, everything is a nail.

Far be it for me and my simple analysis to suggest that central banks everywhere are wrong for going by the standard playbook. But, I do wonder if this overreaction and the pain it causes are entirely necessary.