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Feb. 1, 2022, 9:29 a.m. EST

The Fed is determined to stop wages from rising

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By James K. Galbraith

AUSTIN, Texas (Project Syndicate)—Federal Reserve Chair Jerome Powell has now  committed  to putting monetary policy on a course of rising interest rates, which could boost the short-term rate (on federal funds /zigman2/quotes/210002368/delayed FF00 +0.01% and Treasury bills /zigman2/quotes/211347046/realtime BX:TMUBMUSD03M +1.03% ) by at least  200 basis points  by the end of 2024.

Thus, Powell yielded to pressure from  economists  and  financiers , resurrecting a playbook that the Fed has followed for 50 years—and that should have remained in its vault.

The stated reason for tightening monetary policy is to “fight inflation.” But interest-rate hikes will do nothing to counteract inflation in the short run and will work against price increases in the long run only by bringing on yet another economic crash.

Follow the complete inflation story on MarketWatch

Financial debacle

Behind the policy is a mysterious theory linking interest rates to the  money supply , and the money supply to the price level. This “monetarist” theory goes unstated these days for good reason: it was largely abandoned 40 years ago after it  contributed  to a financial debacle.

In the late 1970s, monetarists promised that if the Fed would focus only on controlling the supply of money, inflation could be tamed without increasing unemployment. In  1981 , Fed Chair Paul Volcker gave it a try. Short-term interest rates soared to  20% , unemployment reached  10% , and Latin America spiraled into a  debt crisis  that nearly took down all the large New York banks. By the end of 1982, the Fed had  backed off .

Since then, there has been  almost no inflation  to fight, owing to low global commodity prices and the rise of China. But the Fed has periodically shadowboxed with “inflation expectations”—raising rates over time to “pre-empt” the invisible demons, and then congratulating itself when none appeared.

The shadowboxing also ends badly. Once borrowers know that rates are going up over time, they tend to load up on cheap debt, fueling speculative booms in real assets (like land) and fake assets (like 1990s internet startups, 2000s subprime mortgages, and now cryptocurrencies).

Meanwhile,  long-term interest rates   /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -0.03% remain unmoved, so the yield curve flattens or even becomes inverted, eventually causing credit markets and the economy to fail. We now will likely see this feedback loop once again.

This time is different

Of course, this time  is  different  in one respect. For the first time in more than 40 years, prices  are  rising. This new phase was kicked off a year ago by a surge in  world oil prices , followed by rising  used-car prices  as the semiconductor supply chain snarled automobile  production . Now, we are also seeing  rising land prices  (among other things), which feeds into (somewhat artificial) estimates of housing costs.

Inflation rates are reported on a 12-month basis, so once any shock hits, it is guaranteed to generate headlines about “inflation” for 11 more months—a boon for the inflation hawks. But since  oil prices   in December were about the same as they were in July, the initial shock will be out of the data in a few months and the inflation reports will change.

True, the  effect  of more expensive energy will continue to percolate through the system. That’s unavoidable. Whenever there is a structural change like an increase in energy costs or a reshoring of parts of the supply chain, “inflation” is  inevitable  and  necessary . To hold average price increases to the previous target, some other prices would have to fall, and that generally doesn’t happen.

The economy always adjusts through an increase in average prices, and this process must continue until the adjustment is finished.

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