Prevailing theory says raising interest rates brings down inflation. How true is that?

The Federal Reserve followed the playbook in 2022. But while inflation came down, the economy didn’t slow as expected.

By Sean Saldana & Aislynn GaddisJuly 2, 2024 2:36 pm,

The Federal Reserve has long operated under the theory that if you want to bring inflation down, the best way to do that is to raise interest rates. 

When interest rates go up and money becomes more expensive to borrow, spending goes down and the economy slows, which should bring down prices. This might trigger a recession, but you do take care of inflation – or so goes the theory.

This theory was put to the test when inflation spiked around 9% in 2022 and the Federal Reserve started raising interest rates. But, while inflation has slowed, parts of the theory may not hold up. 

Rogé Karma, a staff writer at The Atlantic covering economics, claims “No one really knows how interest rates work.” He joined Texas Standard to discuss. Listen to the interview above or read the transcript below.

This transcript has been edited lightly for clarity:

Texas Standard: “No one really knows how interest rates work”? I think there are a lot of econ professors who would beg to differ on that, and certainly the Federal Reserve. You write that, over the past few years, the general direction of our economy hasn’t held up to the old Econ 101 textbook standard. Say a little bit more about that.

Rogé Karma: Sure. So I think a lot of this sort of textbook conventional wisdom about the relationship between interest rates and inflation goes back to the 1970s and the 1980s.

So in the 1970s, you had inflation spiraling out of control. As the story goes, Fed Chair Paul Volcker came in in the early 1980s. He jacked up interest rates to record levels. Threw the economy into a recession, right? Unemployment spiked to 11%.

Those were really tough years, but it worked. Prices stabilized, inflation came down, and Volcker went down as the hero who saved the economy. And really, ever since then, that has been sort of the theory about how interest rates work, right?

As you were saying in your intro, you raise borrowing costs, everyone starts feeling squeezed, so they stop spending. When people stop spending, businesses start making layoffs. Those laid-off workers spend even less. You end up getting into this vicious cycle that ends in a recession. But, inflation is too much money chasing too few goods. So, if everyone has less money, that means less inflation. Problem solved. 

The problem is in this recent period, what happened was inflation reaches 9% in 2022. The Fed starts jacking up interest rates. They go to their highest level in two decades. Everyone – based on the 1980s, based on the textbook definition – starts predicting a recession. You have one Bloomberg model predicting a 100% chance of recession because that’s what’s supposed to happen when you raise interest rates. 

And then over the course of 2023, the economy just keeps booming, right? Unemployment remains at record lows. Consumer spending keeps chugging along. You have economic growth powering ahead and all. Meanwhile, inflation falls from 9% all the way down to 3%, right? All without a hint of interest rates actually having had an impact at all.

Well, now wait minute. Without interest rates having had any impact at all? I mean, as you just mentioned, inflation peaked at around 9% – today we’re around 3% – and most people would say, “well, what else has changed here?” The Federal Reserve starts jacking up, interest rates and we do, in fact, see inflation slowing, do we not?

We absolutely do. But this is the mystery, right? You had the inflation. You had the Federal Reserve raise interest rates. But, according to the textbook theory, the way interest rates work is by slowing down the economy, and then by slowing down the economy, inflation comes down.

So what we end up having, though, is the economy keeps accelerating faster than ever and inflation still comes down. And so it’s really hard to say, “Well that was interest rates.”

What I’m getting confused about is that if the devil here is inflation, that in a perfect world, if you raise [interest] rates and that addresses the issue of inflation – at least, in part – and you don’t trigger a recession, that’s a good thing. It’s a thumbs up. It’s working. We’re doing it right. We’re balancing it.

Perhaps going back to the days of Paul Volcker, when we did go into a recession – and a deep one – and a lot of people lost their jobs… It wasn’t as well calibrated as perhaps the Fed has done this go around. What would you say to that?  

You know, I think that is a perfectly reasonable argument, and I would have two responses.

One – economists will say maybe the way this happened is interest rates played an almost Goldilocks role, right? We don’t actually see the economy slowing down, but without them, unemployment would have been even lower. Wages would have grown even faster, spending would have been even higher.

So even if we don’t see the impact in the data, we can assume that maybe they had a role. That is certainly possible. But, it’s very strange to not see any real evidence in the data, right? 

So, like the sector of the economy that’s typically known as the most sensitive to interest rates, the first place that interest rates show up, is construction. Usually, the first thing that happens when you raise interest rates is it becomes much more expensive to finance big projects like building homes, and so almost in every situation construction employment starts decreasing. In this case, construction employment has actually risen since the Fed started raising interest rates. So you really don’t see it anywhere in the data. 

But, to your point, this leads to a second theory. There’s sort of two textbook theories about how inflation and interest rates relate. One of them is the chain reaction theory that we’ve been talking about, but another is based on expectations.

And, part of the argument there, which may have been the case this time around, is simply by saying that it is going to be addressing inflation, basically, the Fed sends a psychological message, even if it’s not impacting the economy directly. It sends a psychological signal to all these people in the economy that a recession is coming, and inflation is going to be under control. And so people stop spending and they stop hiring on their own, and that might bring us to a more stable equilibrium without the Fed ever having to really inflict economic damage at all.

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