Hiking rates in a shifting economy
I have been critical of the Fed and the Bank of England for some time. In particular, I think by not differentiating enough between supply and demand shocks to inflation, they have made a bad situation worse by hiking interest rates too much. However, I am also of the opinion that there was a demand shock to inflation that needed to be addressed with higher interest rates, just not as many as we got in 2022.
This demand-driven inflation was mostly triggered by supply chain disruptions after the pandemic. People wanted to buy stuff and go out and have fun. Yet, the stuff they wanted to buy was in short supply because countries like China still had covid restrictions on and couldn’t deliver the needed products in time. Similarly, people wanted to go out again, but there was a shortage of service workers. All of this meant that prices for some goods and services rose significantly, while prices for other goods and services dropped a lot (if you are a shareholder of Peloton, you know what I mean). In essence, the problem was less one of aggregate demand across the economy outstripping aggregate supply and more one of shifting preferences so that some parts of the economy faced too little supply to match demand, while other parts of the economy faced too much supply for the waning demand.
If you read Veronica Guerrieri’s analysis of the impact of monetary policy in an economy undergoing such structural shifts you suddenly come to doubt whether rate hikes by the central bank make any sense at all.
The problem is that if central banks hike interest rates, it makes it harder for the sectors of the economy that are facing a demand overhang to expand production capacity. Of course, excess demand in these sectors is declining and this will reduce inflation in the sectors that face a demand overhang, but at the same time, sectors that already have too little demand will see demand drop even more, forcing them to adjust downwards.
This may sound like the usual cycle of creative destruction that happens during every recession but it isn’t. Because the rising prices in sectors with too much demand are not due to cyclically high demand but due to a permanent shift in demand from one sector to another. Cooling off that demand does nothing to cool inflation in the long run. Instead, what the economy needs to do is go through a period of adjustment in relative prices to reflect the permanent changes in relative demand. And hiking interest rate in such a phase only works if the workers who are employed in declining sectors lose their job and then move on to jobs in expanding sectors. But if companies operating in expanding sectors face higher interest rates they are less inclined to hire additional employees or invest in expanding capacity.
All of this is to say that if the central bank in such an environment increases interest rates, all it may achieve is a permanent increase in unemployment rates without taming the inflationary pressures in the expanding sectors.
I am not sure if their analysis is correct, mostly because, as the authors of the research point out, it depends on the impact rate hikes or rate cuts have on the labour force and job creation in different sectors. But it at least puts some doubt on my view that in 2022 we should have hiked interest rates to fight excess demand since the excess demand was very concentrated in specific sectors and not widespread across the economy. Maybe doing what central banks did in 1990 namely not hiking at all would have been the optimal policy decision. If this theory is correct, then central banks in 2022 have already created persistent stagflation by creating unemployment in declining sectors while not curbing price pressures in expanding sectors. I guess we will find out in 2023 and 2024.