What’s Really Causing Inflation?

Sometimes a good graph tells a good story. So it is with the front-page interest-rate graph in today’s New York Times (NYT, page A1, July 28, 2022). Labeled “Federal Funds Target Rate,” it tells a story that no pundit or economist has yet told, to my knowledge, in all the ceaseless hand-wringing about recently rising prices.

(Unfortunately, the graph doesn’t appear in the online version of the New York Times. Apparently it derived from this Fed graph, which appears less dramatic with an extended time scale and a shorter vertical scale.)

The NYT graph covers Fed target rates from 1970 to the present, or 52 years. That’s over half a century. As appropriate for the New York Times, it looks a bit like the Manhattan skyline. The seventies through the nineties look like downtown/Wall-Street skyscrapers, while later years level off to what look like shorter uptown buildings.

But that “uptown” area is unique. Except for a short rise from 2016 to 2020, and except for a pandemic-recovery rise since late 2021, it looks like total demolition. As near as I can eyeball it, the Federal Funds Target Rate was a mere one-quarter point for over two-thirds the thirteen years from fall 2009 to the present. And it fell to and stayed at that rate from late 2009 to early 2016.

Even during the “peaks” in that demolished interval, including the recent pandemic-recovery rise, the rate never got above 2.5%. But the eyeball average (i.e., normal) rate over the preceding thirty-some years was between 5% and 6%.

So here’s the astonishing thing. Since 2009, apparently in response to the Crash of 2008, our Fed has held its target rate to 0.25% for all but a handful of years.

That’s about as close to “free money” as you’ll ever see in this imperfect world. Did it ever occur to our economic gurus that encouraging banks to give away free money for over a decade might increase demand and make prices rise?

It gets worse. Who actually gets that 0.25% interest rate? Not you or me, and certainly not the average worker. That’s the rate at which banks lend each other short-term excess funds. But that rate influences, if not determines, the rates at which banks lend short-term to businesses, which competition among banks also presumably restrains.

Real interest rates that consumers pay are much higher. For this post, I just looked up the rates on my two credit cards: their July APRs for purchases are 10.74% and 16.74%. And I have a high FICO score because I pay off my balances every month.

Two points should be apparent from these figures. First, banks have been making a lot of money for the thirteen years of rock-bottom interest rates. So they can easily pay excessive salaries and indulge in financial speculation.

The second point is more subtle. Businesses and wealthy people have a number of ways to borrow money at rates way below what you and I pay on our credit cards. They have expensive homes with low or no mortgages and big equities on which to borrow. If they have “personal” businesses, such as partnerships, S corporations and LLCs, they can take business loans and borrow from their businesses at whatever rates they please.

So what’s my point here? The rich and business owners can borrow money at artificially low rates, pushed down by the Fed’s consistently low interbank rates for thirteen years. When the economy is going well, as it has been since the post-2008 rate drop did its trick, there’s no reason for them not to borrow, both for their businesses and their own personal consumption. Yachts, mansions and personal jets, anyone?

The end result is, in essence, free money for the rich. This increases demand especially for luxury and “high-end” goods and services. But the excess demand also “trickles down” to things like cars, travel, restaurant meals and even supermarket food. (The rich have to eat and drive, too, although they can more easily afford electric cars, with vastly lower energy and maintenance costs.)

So that’s the big story. With a short and desultory break in 2016-2020, and except for the recent rise—all up to less than 2.5%—the Federal Funds Target Rate has been 0.25% for thirteen years.

Think that long era of free money contributed to the historic rise in stock prices, which just now seems to be unwinding? (Note that the stock market bump started long before the pandemic and continued through uniquely chaotic politics and the worst part of the pandemic, until the Fed got serious about taking the punch bowl away.) Think the free-money party exacerbated financial and social inequities in the US? Think it may have distorted our national economy by increasing demand for, and therefore production of, goods and services that became more “popular” with free money, i.e., luxuries and frivolities? If so, you think like me.

Glibber explanations for inflation make little sense to me, especially pandemic relief. If you pay people as relief less money than their lost salaries, where’s the consumer bonanza, i.e., the increased consumer demand? The breakdown of global supply chains under pandemic stress, and under the slow process of de-globalization now occurring, could affect supply. But I’ve never seen a report of any quantitative study of these phenomena, and the chips that go into most cars come not from China, but from Taiwan, which has suffered far fewer draconian Covid lockdowns.

As for oil and gasoline, I’m skeptical of incessant referrals to “global markets,” as if they were Newton’s First Law of Motion. Do US producers really hire big tanker fleets and send fracked US oil abroad when prices rise in Europe, for example? I doubt it. Or do they just raise prices at home reflexively, hoping that no one will notice that there’s no actual physical connection between domestic and overseas markets? (To my knowledge, there are no overseas oil or gas pipelines, and no railroads running tankers through tunnels under the oceans, so ad hoc hiring of vast tanker fleets is the only feasible method of actual supply.) And do American and Canadian markets really get much grain, corn or other foodstuffs from Ukraine? If not, are higher prices for cereal in US supermarkets more financial exploitation than a reflection of truly interconnected global markets?

At the end of the day, the glib resort to recent and temporary phenomena—including government pandemic-relief spending and Putin’s atrocity in Ukraine—to explain rising prices requires far more detailed quantitative analysis and proof than I have ever seen. Meanwhile, there’s an 800 pound gorilla sitting in the middle of the room, in plain view of all: near-zero Fed interest rates for thirteen years. They started to rise just a bit in 2016 but then were cut back to near-zero again when the pandemic hit.

So the Fed’s been letting banks give away free money for a long time. In my view, it’s going to have to take the punch bowl away convincingly and decisively before the joyous buying binge ends, especially among the wealthy. The risk is not a small recession, which may be necessary, but creating a mindset among banks, businesses, the rich and the rest of us that the free-money party will never end. Isn’t a national economy based on consistently free money a bit pathological?

Before closing, let’s compare the time scales of another anomalous period in the US economy: the interest-rate spikes in the mid-seventies to mid-eighties, when the Federal Funds Target Rate briefly exceeded nineteen percent. (I remember this period well because it kept me from buying, rather than renting, a home for over a decade.)

Economists and politicians made much of the “wage-price” spiral as a cause of inflation in this period. But the underlying cause was foreign and much simpler: the Arab Oil Embargo of 1973-74 and its consequences. The Embargo had political (anti-Israel) origins. But eventually the Arab nations, which had already nationalized their oil fields and formed OPEC, learned economics and took control of global oil prices with their collectively dominant supply. Their cartel raised oil prices steadily and worldwide. It kept them there until the discovery and exploitation of the North Sea oil fields and (later) fracking in the US increased global supply, and Japanese (and later law-mandated) high-mileage cars decreased demand.

Fed Chair Volcker’s draconian interest-rate increases may have curtailed the resulting inflation, and perhaps they were entirely necessary. But, whatever the causes, the rise in interest rates spanned about a decade. Could it be that a similar market stimulus to demand, namely rock-bottom rates, might have an effect of similar longevity? If so, it may be better for the Fed to “stay the course” in taking the punch bowl away until prices and production have adjusted to the end of this more-than-decade-long free-money party.

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