Supply and demand are always interchangeable when it comes to prices. We might compare supply (real GDP) to trend, and find it's been low, and conclude there's a supply and not a demand problem.[1] But the Fed is a bank and can't do much about supply.
Another question is whether inflation is actually high. There was a sharp change in the CPI last June.[2] Measuring from February 2022 still gives 6.0% but measuring from June gives 3.5%/year. There's also the question of inflation stability (2nd derivative of prices), and things have been pretty smooth since June.
So should the Fed crash the economy to try to bring stable 3.5% inflation down to 2%? Probably not. But the bigger question is: What can we do to increase supply?
[1] 1.7%/year 2022Q4/2019Q4 versus 2.6%/year 2019Q4/2016Q4 or 4.7%/year 1999Q4/1996Q4 etc.
In the real world - both can happen simultaneously.
When interest rates rise, not only does higher cost of borrowing discourage investments and spending (an attempt to kill demand to bring down prices) it also reduces the money supply of the economy.
The money supply refers to all the liquid assets and cash that are in circulation in a country's economy. It is important because it is closely related to the credit market.
But money supply works in conjunction with market risk - which often branches out to two functions - liquidity preference and risk premium. The former is a theory that suggests that an investor might prefer 6% over 10 years than 3% over 5 years. The latter suggests that one investor might pick the 3% (lower yield) option because it has better risk premium - say the 6% is a bond in a DVD store, and the 3% is a government bond (example).
What we're witnessing now is the spiralling, second order effects of rising rates - which on the one hand attempt to kill demand and curb prices for consumer goods, but on the other, affect the money supply and force investors to rebalance their portfolio and start evaluating different risk premiums.
The Fed has dug itself into a hole because monetary policy changes have massive spillover effects into other areas of the economy, not just inflation and cost of borrowing, but also things like how participants in the economy view liquidity and risk premiums.
Can't A/B test monetary policy, or life. Institutions, like people, will learn to face the consequences of their actions and learn to live with their choices.
The long answer is that today's inflation doesn't seem to be monetary in cause, because nearly every country is experiencing inflation simultaneously. If the Fed had printed too much money and that was why the US was inflated, that dynamic shouldn't really affect, say, Germany, or Brazil. (Caveats abound, of course). Despite that, we're seeing nearly every major country have similar and sustained rates of inflation across monetary policy regimes.
So, we know there's been something that affected everyone globally, and that's obviously supply chain disruptions along with gas and oil price changes due to Ukraine. Fed policy didn't cause the inflation, something bigger than the Fed did.
The question then is can the Fed fix it. The answer here is maybe. The Fed has tools to fix inflation - when the inflation is caused by monetary policy reasons - and those tools should, all else held equal, reduce inflation eventually.
The real question is whether or not the Fed is the best entity suited to tackling today's inflation. Politically, it's very easy to just delegate all that stuff to the Fed so that it becomes some technocratic thing that's essentially beyond the scope of normal politics. This is what Reagan did in the early 80s. But in terms of actually fixing the underlying problems, I don't know how much impact the Fed can have.
Raising rates won't make supply chains readjust to today's geopolitical environment, or hire more truckers to move long-stored inventory. It will fix the monetary part of the inflation, but to get back to your question, nobody really knows what the monetary part is. It's less than we'd normally think, but we don't know precisely.
This is a pretty exhaustive text on why this is the case, I found it quite convincing:
"The inflation economy" https://graymirror.substack.com/p/the-inflation-economy
"The golden age of informal securities" https://graymirror.substack.com/p/the-golden-age-of-informal-securities
"Bitvana or the bitcaust" https://graymirror.substack.com/p/bitvana-or-the-bitcaustFor hyperbole, houses would never sell for millions of dollars, if only 2 dollars existed in the worldwide economy, not even if the housing shortage was so bad that there only was 1 house available in the entire world. People may try as they might, but they'd never get more than the total money in existence (2 dollars). Ergo it's entirely possible to make a money shortage worse than any "supply" shortage and force prices down. The Fed controls interest rates, and how many dollars exist, so they do have quite a bit of influence over the situation.
So, yes the Fed does have power to tame the current bout of inflation, but it takes time, and it is blunt. That said, there is a ceiling to how much money they can suck out of the economy, as they have little power to destroy dollars physically hoarded by people with no debt, or lost in a roadside ditch somewhere. But this doesn't matter much, as that money in practice, is out of the economy for the time being, as if it doesn't exist anyhow.
Putting the subject of inflation aside for the moment, the first cause is the destruction of capital. Capital destruction, which broadly speaking includes our ability to transport goods, has curbed the economy's productive capacity. We produce less, and so what we are able to produce becomes more dear. This is the supply issue, but it's not inflation.
The second cause is inflation. The definition of inflation I'm using is the increase in the money supply. Until very recently, this is what the Fed (and other central banks) have been doing. More money chasing the same amount of goods—all else being equal—causes a rise in prices. This is the demand issue.
I realize that this understanding and use of the term inflation isn't mainstream. But I think it makes it easier to understand what is going on.
I recommend Manoj Pradhan & Charles Goodhart’s, “The Great Demographic Reversal” (2019) for more on the topic.
Covid occurring since then has exacerbated the international debt issues, as well as plucked more of the valuable remaining years away from our labor force’s working years. See the number of early retirements that occurred during the pandemic.
That we’re also seeing a hot war, a trade war, and the ripples of a goosed economic system during covid at the same time? Can’t make it up.
Edit: I wouldn’t hold my breath waiting for the fed to resolve this, they’d have to crush assets to oblivion to keep pricing of labor the same as it dries up due to retirements.
AI on the other hand has a lot of potential to bail us out here
The main catalyst, and by that I mean essentially the only catalyst, is monetary policy.
https://www.reuters.com/business/retail-consumer/carrefour-p....
I imagine its like this all over which each part of the logistical chain opportunistically cashing in using the excuse of inflation.
SF Fed breaks out the PCE index by supply and demand:
https://www.frbsf.org/economic-research/indicators-data/supp...
On the other hand I don't know squat about monetary policy, so I'm probably confused.
I think one could argue they exacerbate inflation - rising prices can trigger more price increases, but in the end its money supply that drives an erosion of the value of currency.
To your question: what it comes down to is that the fed is charged with managing inflation and unemployment. Regardless of the effectiveness of their tools, they are required to do what they are able to do. With that in mind, it’s possible that there is a better course of action.
Personally I find the arguments of MMT to be strong. This forum has charactered the theory as an excuse for profligate spending, however, the actual proponents simply state that budget deficit are ok so long as inflation is under control. Therefore, the theory would posit that the actual resolution to this would be to shrink the deficit spend in order to properly tame inflation.
Take that for what you will.
As we discovered with some recent bank failures, it is somewhat more complicated than this. People did not just use the new money to buy stuff. They also used it to invest, and a lot of those investments would not have made sense if interest rates were higher. Somewhere I saw the example of an "AI dog-washing startup"; this fake business illustrates the type of real but not necessarily sound business that was suddenly getting investment because there was a lot of money flying around inside the economy. Now, when the Fed "raised interest rates," what actually happened was it created new investment vehicles (e.g. treasury bonds) that offered returns on investment that were much more attractive to investors than the previous generation that offered low/zero interest. Banks and others shifted towards these new, better investments and tried to sell their old, worse ones. Hence, some of the money that was flying around began to exit the economy and return to the government coffers. This was bad for banks like SVB that had a lot of "interest rate risk." It was also bad for downstream investments like the AI dog-washing startup, which were now competing with "better" businesses in an environment with less money flying around—this is where you see e.g. the current tech hiring downturn and layoffs.
So that's about what the Fed has been able to do. One assumption you've highlighted here is, to what extent is the Fed doing all this based on research and deliberation? I think the short answer is, we don't know. Interest rates are indeed a blunt instrument, but they are also the instrument the Fed can control, and so that's what the Fed is using. This leaves a lot of room for conspiracy theories and speculation. I happen to think the Fed is doing its best within the constraints of its powers, but the Fed cannot singlehandedly "fix the economy." They can print money and adjust interest rates. And doing these things affects the economy in theoretically well-understood ways.
Ultimately, raising rates is like putting an ice pack on an injury. It reduces the swelling, which is helpful, but it doesn't fix the injury per se—the fixing happens in an entirely different, more complex system, really a system of systems. Just so with "the economy." The economy ultimately exists as a sort of distributed phenomenon in the thoughts and actions of all its participants. These thoughts and actions are not aligned, and so we get the infinite omni-directional tug-of-war known as the "invisible hand of the market." The Fed certainly has a lot of ways to influence the economy, but it cannot force people to think or act in precise, coordinated ways.