September’s headline consumer price inflation was 1.2 percent and it was 4.7 percent for the past year. However, core inflation, which excludes volatile food and energy prices, was just 0.1 percent in September and was only 2.0 percent for the entire year. Despite core inflation holding at this subdued rate for the past five months, the Federal Reserve has embarked on an interest rate-raising crusade. This campaign is on the verge of killing the patient, and it is time for the Fed to take an inflation chill pill.
Today’s headline inflation is being driven by a series of energy supply shocks, which include Hurricane Katrina and higher oil consumption in China that diverts supply from the United States. These shocks cannot be addressed by raising interest rates. Higher rates do not pump more oil. Instead, interest rates are a tool for managing the overall level of demand in an economy. And the continuing stable low rate of core inflation is evidence that demand remains in balance, so that there is no need for higher interest rates on this score.
The Fed must stop and think about the nature of the energy supply shock. If it is a temporary shock, prices will come back down when the shock reverses. By temporarily driving up prices, the market is actually doing what it is supposed to, so there is no case for higher interest rates. Moreover, higher energy prices have already reduced income for spending on other things, and this is itself anti-inflationary.
If the supply shock is permanent, prices will stay permanently higher owing to permanently reduced supply. However, that does not mean permanently higher inflation. It means a one-time jump in the inflation rate. Again, the market is working, and again there is no case for higher interest rates. The only time a supply shock might warrant higher interest rates is if it triggers a repetitive price – cost spiral, and as yet there is no evidence of that.
One area where demand inflation has been visible is the housing market. That market is a serious concern, and inflated home prices have distorted household saving decisions and encouraged taking on of dangerous debt burdens. But housing prices are cooling, and neither have they caused generalized inflation. That points to a need to tackle the house price problem by spotlighting the bubble and by regulatory measures governing provision of credit, not by the blunderbuss of interest rates that harms other innocent sectors.
Finally, there is one additional area where the Fed has a problem, but that problem is of its own making. There is an argument that the Fed has been so definite about its determination to stamp out inflation that financial markets now expect it to raise rates. Not to raise rates risks markets interpreting the economy as being in the tank, thereby triggering financial market turmoil. Ergo, the Fed must raise rates to prevent disruptive turmoil. This argument is ludicrous. Because financial markets want to push the economy over the cliff, the Fed should not volunteer to do so instead.