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The world economy is a mess and is getting more and more disorderly. In recent months, the Federal Reserve has been rapidly raising interest rates to stabilize prices. But core inflation, a price basket that excludes food and energy, is holding up, and the US labor market is galloping, despite some subtle signs of slowing. And even if the Fed fails to get inflation under control here, it creates other kinds of pain here and around the world.
These rising interest rates make investors look for reliable rates of return. They buy US bonds, which takes US dollars, which causes other currencies to lose value. In a so-called catastrophic dollar loop scenario, countries with cascading currencies go into recession, which further weakens their currencies against the dollar. All of this contributed to the economist Adam Tooze calls a “South Asian polycrisis”, in which highly indebted countries struggle to pay their creditors and energy prices soar. Other central banks are also raising interest rates to stabilize prices, which could contribute to a coordinated global slowdown. Global market risk is surgeand the United Nations now said a global recession is almost certain.
The Fed could be the most powerful economic institution in the world. So why was he better at accidentally exporting global chaos than deliberately reducing underlying inflation at home?
Here is my best attempt to explain what is going on. Let’s say you have a fever. This is the highest temperature you can remember seeing on a thermometer in years. You go to your medicine cabinet and find that all you have is Tylenol. So you go full goblin mode on those suckers. After a triple dose of Tylenol, you feel a slight stomach ache. But the fever keeps getting worse, so you take what you have: more Tylenol. A few hours later, your belly looks like a pincushion with a dozen needles stuck in it. But the fever is still raging! So you take another Tylenol, and another…
In this analogy, you are the Federal Reserve. The fever is American inflation. The medicine cabinet is the Fed’s limited toolbox, and the pills are interest rate hikes. Around the world, the negative side effects of a mild overdose of acetaminophen take shape before the positive direct effects of fever alleviation.
My analogy is a bit exaggerated, I admit. But the fundamental point is serious: the Fed cabinet is really limited in its offers. His toolkit consists of interest rate hikes, securities purchases, and… say it all, all rather blunt instruments for a project like reducing domestic demand by increasing the unemployment rate. The United States is a service economy, whose largest industries – health care, education and professional services, such as marketing and media – are not sensitive to moderate increases in interest rates. If interest rates go up 100 basis points, no one’s back pain goes away and kids still have to go to school.
So, just as ibuprofen does not instantly reduce fever, the effect of interest rates on service employment is somewhat indirect. Let’s say the Federal Reserve wants to target inflation by weakening the labor market in the booming leisure and hospitality category. Here’s one way that might work. The Fed is raising interest rates, increasing the cost of borrowing money across the economy, which will make it more expensive for businesses and households to grow, causing businesses to stall high growth, which will create a hiring freeze in certain sectors, which will reduce total wages by putting some people out of work, which means that these people will have less money to spend in hotels, which will mean less reservations in hotels, which will mean that hotels will have to lay off, which will mean increased unemployment in the service industry, which will mean less demand among these households, which will help lower inflation.
Doesn’t that seem oddly twisted? It kind of is. Especially in relation to fiscal policy. If a state government decides the hotel industry is a nuisance, it can quadruple the lodging tax. If he decides hotel workers are too poor, he can pass a law to send a check to every household whose adjusted gross income was below the national average last year, and that will basically do the trick. But there is no simple mechanism for the Federal Reserve to commandeer the US travel industry and institute a hiring freeze in hotels.
To be clear, I don’t think the policy goals of the Fed are wrong or unreasonable. If inflation continues unabated, it will devour real wage gains for years. Everything will feel more expensive. Even if your salary increases, your income will decrease compared to the price of food, apartments, chairs, telephones, dinners and diapers. That’s about as desirable as living with an indefinite 103 degree fever.
But right now, the Fed could afford to backtrack on its fierce rate-hike schedule to let the side effects of its fever-reducing strategy play out. Rent inflation, which peaked earlier this year, may not be visible in official government statistics for another quarter. If so, the Fed is further along in its goal of reducing underlying inflation than today’s numbers suggest. Some fevers take pills, and others require patience.
