The Fed’s tools won’t curb pandemic-related inflation

It is what it is.
It is what it is.
Image: REUTERS/Kevin Lamarque/File Photo
We may earn a commission from links on this page.

With inflation rising at historic rates, Americans are increasingly looking to the US Federal Reserve to step in and tap the brakes on the economy.

The Fed is the only independent institution that has a congressional mandate to make sure prices are stable in the US economy. In November, inflation grew at the fastest pace since 1982, at an annual rate of 6.8% in November, data released Friday (Dec. 10) showed. The increase was in line with economists’ expectations and was driven by higher prices for gas, food, and shelter.

However, the Fed’s main tool to tame inflation—raising interest rates—will do little to fix the supply chain constraints that are bumping up prices. By hiking rates now, the Fed risks stalling the economic recovery without really budging prices in the short term.

Why is inflation rising? 

The Fed is used to stepping in when a hot economy is driving up prices and wages. This time around, however, the increases are due to pandemic-related disruptions. Despite the pandemic recession, many Americans have cash to spend thanks to government stimulus payments, but they can’t readily find what they want to buy on store shelves because covid-19 has backed up manufacturing and shipping. It doesn’t help that they’re mostly buying goods, not services, which has further burdened supply chains.

Returning inflation to the Fed’s 2% target would take substantial hikes over several quarters that would damage the economy and potentially derail the recovery. “Moving heaven and Earth to have monetary policy instantly achieve 2% inflation would not be optimal monetary policy in the current environment,” Wendy Edelberg, a senior fellow in economic studies at the Brookings Institution.

Given this scenario, holding off until mid-2022 to hike rates, as the Fed has indicated it wants to do, makes sense. The central bank is already pulling another of its inflation levers to lower asset prices—in November it started tapering its bond-purchases. (According to University of Chicago economist Michael Weber, for every $100 increase in asset valuation, consumers will spend $3 to $4 more dollars than they normally would.) So unless long-term inflation expectations rise unexpectedly, the Fed can sit on its hands, Edelberg added.

When should the Fed raise interest rates?

Up to now, the main driver of inflation has been consumer goods, items such as used cars, gasoline, and electronics. But if prices for services were to push the overall inflation rate up even after prices for goods cool off, the Fed should pick up its pace of monetary tightening, Edelberg said.

More expensive services would be a sign that the labor supply is too weak to meet demand. “We’re going to need labor supply in the services sector to increase in a way that keeps pace with the labor demand,” she said.

There are no signs of that happening yet. Currently around 20% of those who are unemployed on any given month drop out of the labor force. But every month, other people start working as well, so the churn has held pretty steady and the labor force participation rate hasn’t moved wildly up or down.

Can Congress do anything about inflation?

In the meantime, Congress could pass legislation to encourage workers to come back into the workforce, helping employers better navigate supply chain snags.

For example, an extension of the Childcare Tax Credit as proposed in the current version of the Build Back Better (BBB) legislation would not only provide families with extra cash to pay for higher prices, but help mothers return and stay in the labor force. Similarly, the paid family and medical leave in the bill would reassure workers who are worried about going back to the workplace due to poor working conditions, said Rose Khattar, an economist at American Progress, a progressive think tank.

The government could also raise the minimum wage. Because the policy would be rolled out over several years, it wouldn’t immediately affect inflation, but it would give workers the expectation that they won’t be left behind.

“That way it’s not up to individual employers to offer better benefits or better wages,” Khattar said.