Why the Federal Reserve System's interest rate hike not enough to lower inflation?

The Federal Reserve System's interest rate hike is a key instrument in its toolkit for controlling inflation, but it is not always sufficient to lower inflation, particularly in certain economic contexts. To understand why, we need to delve into the complexities of inflation dynamics and consider some real-world examples.

1. Supply-side Shocks: One primary reason why interest rate hikes may not effectively lower inflation is the presence of supply-side shocks. These are sudden and often unpredictable events that disrupt the supply of goods and services. For instance, imagine a scenario where a major oil-producing nation experiences political instability, leading to a sharp increase in oil prices. This sudden surge in energy costs can ripple through the economy, causing prices to rise across various sectors. An interest rate hike, which primarily influences demand, would have limited impact on such a situation. In this case, inflation is being driven by external supply constraints, making it resistant to monetary policy adjustments.
2. Inflation Expectations: Inflation is not just about current price levels; it also depends on expectations about future prices. If people and businesses expect prices to continue rising, they may act accordingly by demanding higher wages and increasing prices, which can become a self-fulfilling prophecy. For example, during the 1970s, the U.S. experienced stagflation, a period of stagnant economic growth and high inflation. Despite raising interest rates, the Fed struggled to rein in inflation because expectations had become deeply entrenched, leading to a wage-price spiral.
3. Lags in Monetary Policy: Monetary policy, including interest rate changes, operates with lags. It takes time for changes in interest rates to affect borrowing, spending, and investment decisions in the real economy. For instance, if the Fed raises interest rates to combat inflation, it might take several months or even years for these changes to fully influence consumer and business behavior. In the meantime, inflationary pressures can persist or even worsen. This lag was evident during the global financial crisis of 2008 when the Fed cut interest rates aggressively, but inflation remained low due to the time it took for these cuts to stimulate economic activity.
4. Global Interconnectedness: In today's globalized world, domestic inflation can be influenced by international factors. For example, if a major trading partner experiences high inflation or devalues its currency, it can lead to higher import prices and contribute to domestic inflation, even if the central bank raises interest rates domestically. This external influence can limit the effectiveness of domestic monetary policy in controlling inflation.

In conclusion, while the Federal Reserve's interest rate hikes are a potent tool for managing inflation, they are not a panacea. Their effectiveness can be hampered by supply-side shocks, entrenched inflation expectations, lags in the transmission mechanism, and global interconnectedness. To effectively combat inflation, central banks may need to employ a combination of monetary policy tools and work in conjunction with other policy measures, such as fiscal policy or structural reforms, to address the underlying causes of inflation and ensure price stability in the economy.