SOURCE: Let’s talk about today’s big news on the inflation front: What is the Fed trying to achieve by raising interest rates, and what are some potential consequences? 

The Fed has what’s called a dual mandate. They are tasked with using their monetary authority powers to attempt to achieve maximum employment and price stability. Instead of being rigid or having absolute goals such as everyone working or no price changes, these mandates tend to be interpreted by the Fed as avoiding excessive or detrimental levels of unemployment or inflation.

So, while the Fed is aware that more people could be employed given the record number of job openings, the currently low national unemployment rate and persistently high inflation means the Fed is currently more focused on the second part of its mandate.

As for the consequences of the Fed’s rate increases, there are many channels by which these rate hikes impact what we sometimes call the “real” (or nonfinancial) economy. However, there are two classic ones that are mostly likely to impact inflation. 

The first one is that higher interest rates make it more expensive for businesses, who use loans to finance their operations and thus are sensitive to interest rates, to maintain or expand their current operations and output. If a lot of firms only maintain or even contract their operations, demand for labor will also moderate and thereby likely reduce household incomes and consumption, reducing pressure on prices. 

The other less indirect route by which rate hikes could reduce inflation is by raising consumer borrowing costs for goods that are usually purchased on credit via mortgages, car loans, credit cards, etc. This reduction in purchasing power would also reduce consumer demand.

Could this trigger a recession? 

It will certainly cause an economic slowdown. Whether that turns into a recession remains to be seen. 

What we’re hoping for is a soft landing. However, the Fed unfortunately has a relatively spotty record in achieving such landings. That’s partly because the U.S. economy is a very large, very complex system, and interest rates are quite a blunt policy tool by comparison. 

Why is inflation so high in the first place? 

The basic idea is that everything in economics is supply and demand. Right now, we have more demand than usual for goods and services, and that’s in large part because of the fact people have more money than usual in their savings as a result of not spending as much money during the pandemic. 

Now that the pandemic is less top of mind, people are going out again and they want to spend that money on things like vacations or better food, driving up demand. 

It’s kind of an unfortunate coincidence that, at the same time this is happening, we have a supply contraction. Why is that? First, China, one of our major manufacturers, has a COVID-19 outbreak. Container ships are also incredibly expensive these days, and these are how the U.S. receives most of its imports from China. 

The war in Ukraine is not insignificant either. Russia is a huge supplier of fossil fuels, and because of the war and the ensuing sanctions, gas prices are higher. Gas prices play a role in everything, since if it costs more to transport a good to consumers, it makes that item more expensive in general. 

Ukraine is also one of the world’s largest suppliers of fertilizer, which increases food prices.

Who is to blame for the high inflation? 

It’s easy to play the blame game. The president is really getting hammered on it, but he arguably has very little to do with inflation. 

There does seem to be evidence to suggest that large companies are playing a meaningful part in driving inflation, given that they have managed to expand their profit margins in the face of other shocks that might normally explain broad price increases. If businesses were merely passing along the price impacts of supply shocks to inputs, then we would not expect to see widening margins. 

Businesses’ ability to implement these margin-fattening price increases is in turn a result of long-run trends of increased industrial concentration across many industries. This is a phenomenon that predates the pandemic by decades and is the result of repeated policy decisions by the Department of Justice under both Democratic and Republican presidents to not fight increasing market power by firms. In essence, their stance was that increased concentration and reduced competition was acceptable so long as it didn’t result in higher prices for consumers. It may be time for them to revisit this philosophy.

However, the institution directly tasked with combating inflation is the Fed, which as we discussed, just took significant action. The results are yet to be seen. 

When can we expect inflation to begin leveling off? 

The Colorado economy may have peaked – in the last report, inflation was down to 8.3% from 9.1%, which is the first drop we’ve seen in a year and a half. That’s below the national average of 8.6%. 

Colorado may have peaked, but it’s too early to tell. I’m hopeful about the soft landing following the increase in interest rates, but I think it’s going to take a while. 

It’s not going to happen next month, I can say that for sure. I like to believe that by the end of the year we’re going to see turning points in the economy. 

Why is Colorado below the national average for inflation? 

Colorado is actually at the lower end of the scale because we have Suncor, an oil refinery in Commerce City, that produces 100,000 gallons of gasoline per day, and 95% of that goes to the nearby Front Range. 

That means the state actually has our own little bit of energy independence, so we’re better off than other areas. 

In addition, the state has numerous oil wells that are a relatively short trip to the refinery, saving transportation costs. 

Your research deals with the urban and rural divide. Is inflation worse in rural areas? 

It does have more of an impact. Part of the problem is transportation: In Colorado, all the major distribution centers are on the Front Range, so it costs money to move supplies from Denver to other parts of the state. 

The increase in gas prices means it’s more expensive to get food to rural markets and supplies to rural hospitals. In effect, everything is more expensive. 

In addition, rural residents tend to not have as many resources as urban residents. If inflation goes up, necessities like food take up a larger part of a family’s budget. When staples like eggs double in price, that’s a real difference for less wealthy households.