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Fed Policy: Looking in the Wrong End of the Telescope

This piece was originally published in The Hill


The Federal Reserve has raised interest rates five times this year, essentially doubling them. Its rationale is that higher rates will curb inflation by reducing demand, especially in interest-sensitive sectors like housing and car purchases. The newly elected Republican House majority will try to reduce demand further by pressing fiercely to “cut spending.” A recession brought on by these policies will serve the Republican’s political purposes, and they know it.


The Fed and the economists and pundits favoring these policies, if we take their economic rationale at face value, are looking through the wrong end of the telescope. The causes of today’s inflation are not government and private spending. They are supply shocks in crucial sectors, principally energy. These post-Covid disruptions are being driven by the OPEC oil cartel, war in Ukraine and Russia’s efforts to use energy to force members of the European Union to stay on the sidelines in this war.


Worldwide reductions in energy supplies and the world’s vulnerability to OPEC’s decisions will not be fixed by higher rates or spending cuts. They will not make energy products — gasoline for cars and trucks, natural gas for home heating, electric generation and industry, diesel for trucks and heavy equipment, fertilizer, heating oil, propane — more available at lower prices. Worse, high energy prices raise the cost of almost every good and service Americans buy. 


Inflation driven by energy prices is not new. The OPEC cartel curtailed oil production in the 1970s and was a primary cause of that decade’s very high inflation. Are the members of the Federal Reserve Board and the deficit hawks really serious when they argue that the way to deal with these energy supply problems is to raise interest rates and reduce demand for energy products?  


Supply issues are driving price increases in non-energy products as well. Higher interest rates and spending cuts will not bring down inflation in dairy products, milk, cheese, butter and ice-cream. Price increases in these products are the result of a reduction in dairy herds during the pandemic that will take time to resolve. Prices of wheat products and feed have been affected by drought and floods on several continents, and of course by the oil cartel and war in Ukraine. How will higher rates and spending cuts encourage farmers to rebuild egg, chicken and turkey production reduced by avian flu this year?


Shortages of some types of computer chips and other high-tech parts for our fast-changing economy beg the same question. Will higher rates and spending cuts increase or decrease investment in high-tech areas? What about our antiquated transportation infrastructure, electric generating facilities and electric grid? President Biden is funneling government money into efforts to increase production and investment in these sectors. A recession engineered by the Fed and Republicans in Congress will reduce private sector investment in these sectors, especially by smaller credit-dependent players. It will not add to supply.


There are other areas where domestic price-fixing is causing inflation. Solutions in these areas will require difficult political decisions, not higher interest rates and spending cuts. U.S. health care costs rise every year and cost at a minimum one-third more than in Europe and Canada. Health care is dominated by local vendor monopolies, costly and medically useless insurance and payment arrangements. Everyone knows that American health care is an expensive paperwork nightmare but the politics of attacking these cozy price-fixing arrangements is daunting. 


Executive compensation is another area where the fix is in. Again, everyone knows it. Executives stack their boards and boost their own pay and benefits in plain sight while complaining about the high cost of labor. The Fed’s broad brush monetarist approach serves to take the public’s eye off the outrageous abuses of these boardroom price fixers. 


The solution would be reforms in corporate governance to root out inflationary self-dealing, but Republicans don’t want the government to make corporations play it straight. That’s why they focus on interest rates and government spending as the causes of inflation. It diverts the public from pointing fingers at well-heeled and well-lawyered culprits. Suffice it to say that early in our history corporations were given extraordinary powers by the government to achieve public purposes, not just to enrich their boards and shareholders. 


College tuition is another area where there is soaring inflation because of the gold-plating of facilities and huge paydays. College executives get million-dollar contracts. Higher interest rates and spending cuts will do little to bring these steadily rising costs down. That will take political action.


President Gerald Ford held the Whip Inflation Now (WIN) conference in November 1974. The professors and business titans that Ford assembled all told him he should risk a recession by raising interest rates and cutting government spending, exactly what the conventional wisdom says today. A notable exception was professor Otto Eckstein of Harvard, who had served on President Lyndon Johnson’s Council of Economic Advisors (1964-1966) and founded Data Resource Inc., a famous early economic consulting firm. Eckstein said at the conference that the government should fight inflation by opening up industries where government-sanctioned price fixing arrangements were driving up prices. By the mid-1980s, President Ford, Carter and Reagan had opened many of these sectors to increased competition — domestic oil, natural gas and electricity, automobile and related manufacturing, trucking, railroads, airlines, telecommunications, finance, and even retailing. As a result, inflation was not a serious problem for the next 35 years, until the OPEC cartel regained power. 


The U.S. should shadow Eckstein’s approach for dealing with inflation today by attacking price fixing and investing in alternative energy that will gradually free us from OPEC’s domination. There needs to be more private and public investment in specific areas where inflation is a persistent problem and better public supervision of price fixing arrangements that have been driving prices up. This is essentially what President Biden’s infrastructure and anti-inflation policies are targeting, but the Fed’s monetarist policies undermine sensible thinking about ways to increase supply. 

We need to look through the right end of the telescope and focus on ways to increase supply, not pretend that inflation is a problem of over-consumption that can be solved by causing a recession. 

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