Broken Strategy: Increase Interest Rate to Tame Inflation

Fed is increasing interest rate aggressively to tame inflation. This strategy to tame inflation is by reducing demand. Paradoxically, it means Fed is actually making things more expensive, otherwise why would you reduce demand? As an example, if you are buying a home or a car, even if the price increase is tamed, your monthly payment will be higher. So, inflation when measured in terms of ticket prices, increasing interest rate may decrease it, but in terms of total price paid by the consumers, inflation actually goes up with increased interest rate. It is just that a greater part of the payment is going to a lender.

Another mechanism by which increasing interest rate reduces inflation is by making investments more expensive. Businesses anyway lose some of their revenue to the payment made by their customers to the bankers. Now, since the cost of investment has gone up, businesses will have additional reason to reduce their investment. Therefore, layoffs and/or decrease in salaries reduce inflation.

Both of these mechanisms actually hurt people more than inflation would have hurt. As an analogy, in order to avoid theft at your home, would you simply burn your valuables?

Now there are other mechanisms which are at play in reducing inflation. When dollar earns more interest, a dollar becomes more valuable. This is easy to see in terms of exchange rates. Appreciation of dollar reduces the cost of imported goods and services, which has some impact on reducing inflation. This aspect is zero sum though, since other countries may increase their interest rates too. Additionally, the same increase in dollar's value lowers the asset pricing in the US itself. If the dollar is 10% more valuable, then 10% fewer dollars will buy the same asset. The decrease in asset pricing gives a negative feeling to consumers, therefore people reduce their spending. It gives a negative feeling to businesses too, so they reduce their hiring, or worse start laying off employees.

I think, increasing interest rate to tame inflation is overall an outdated strategy. It does not do much to increase supply, but it reduces demand, which inflation anyway will do. But increasing interest rate lowers that demand even faster and deeper, which is a sign that it is actually worsening the affordability for consumers. Overall, we want to see growing prosperity, which also means people be able to afford goods and services more easily. But if increasing interest rate were improving affordability, then demand would not go down, therefore increasing interest rate would not have reduced inflation.

Low interest rates are needed to increase investment, which in turn improves affordability. I am of the opinion that artificial cost structure is suboptimal and outdated. In case, debt is guaranteed to be returned on time as promised, the safe interest rate should be close to zero. The risk adjusted interest rate should be whatever the risk perception is. Therefore, if we want to reduce the liquidity in the economy, a better way is to increase taxation on undesirable consumption. That way, you can finetune which consumption should be reduced. The undesirable consumptions are often those which consume our limited resources and damage our planet or harm us. Consumption which requires employment is actually desired consumption, since it keeps people employed, wages high, and use human productivity to make us all prosperous.

While we have made humongous progress in various fields of sciences, we have not made as much progress in economic science. Economic science is falling drastically behind all the social and technological progress we have been seeing. This is perhaps the reason why we still use outdated economic tools and pray that they work. May be Fed action will decrease inflation, but there will be no way to evaluate whether we would have been better off if the inflation had cooled down by itself.