Why the Fed Must Continue to Raise Interest Rates

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The recently released inflation numbers indicate that inflationary pressures are building. That means the Federal Reserve must continue to act aggressively with its interest rate increases. When inflation seemed to moderate in the summer, the hope was that the Fed had raised interest rates enough. The newest data suggests that’s not the case.

Although the Fed measures inflation using the Personal Consumption Expenditure, the best measure of consumer inflation in the Consumer Price Index. In July, the CPI didn’t increase at all. In August, the CPI increased by only 0.1%. Inflation seemed to disappear.

But the CPI increased by 0.4% in September. Indications are that the monthly CPI will increase by a full 1% or more in the coming months. That means by year-end we could see annual inflation near double-digit levels.

The explanation for the widely fluctuating monthly CPI number has to do almost entirely with energy prices, which account for nearly one-third of the CPI. Declining demand mostly due to slowing worldwide economic activity caused energy prices to fall by about 5% in July, more than 10% in August and another nearly 5% in September.

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Since the CPI was positive the prices of everything other than energy were rising quickly. In fact, if both food and energy are removed from the CPI, the core annual inflation rate was 6.6% in September. With energy prices rising in October and OPEC planning to cut production because of lower expected demand, energy prices will rise significantly in the months ahead.

Food price inflation is also increasing. Rising costs for fertilizer, labor and diesel fuel mean domestic farmers will seek higher prices for this year’s harvest. Internationally with 25% of the world’s wheat supply produced in Russia and Ukraine, the reduction in supply due to the war will force prices up.

That means with the 6.6% core inflation and rising energy and food prices, the annual CPI will accelerate in the coming months.

Although the Fed followed shockingly irresponsible monetary policy last year, which contributed significantly to the inflation problem, fed officials have finally reversed their policy. For some reason, in all of 2021, the Fed ignored the primary goal of Monetary Policy. That is, to ensure price stability.

Finally, in March of this year, the Fed completely ended their bond-buying program and began to raise interest rates. By June they realized that interest rates were way too low to fight inflation. That meant they would raise rates by 75 basis points in June. The Fed hadn’t had a rate increase of that size since 1994.

Since inflation reached 9% by then, more aggressive rate hikes were needed. They raised rates by 75 basis points in July and another 75 basis points in September. The hope was that would be enough to bring inflation down. It turns out it isn’t.

That means the Fed will likely raise rates by at least 75 basis points in November and another 75 basis points in December. That still won’t be enough. It may be that real interest rates must be positive before inflation will fall. That means interest rates must be higher than the inflation rate.

If the Fed softens its policy because the rapid increase in interest rates is causing a global recession, inflation will worsen. It is critical that inflation be brought down to an acceptable level as soon as possible. The longer it takes to reduce inflation, the tougher it becomes. Taking a soft approach will lead to embedded inflation coupled with a potential wage-price spiral which is already developing and is extremely difficult to end.

Organized labor and even independent workers are demanding larger wage increases just to “keep up with inflation.” Even Social Security recipients are getting an 8.7% increase in benefits next year. Workers will rally around that 8.7% figure and insist on raises in that range. Once that happens, the resulting increase in labor cost for business will put upward pressure on prices and keep inflation high.

Inflation is a cancer that, if left untreated, will spread throughout the entire economy and become entrenched. Inflation yields so many negative consequences, particularly noted by a reduced standard of living mostly felt by lower income workers and retirees.

The latest data shows that the Fed must get even more aggressive with interest rate hikes, even if those hikes lead to a global recession.

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