In today’s YouTube video I argue that the Federal Reserve will have engineer a recession if it is serious about bringing inflation under control.
This post gets more into the specific details of why I think that’s true than the video does. (I suggest reading this and watching the video “We’re headed to a recession.”)
The Federal Reserve isn’t staffed by mean old orcs (as far as I know) determined to bring on a recession because they think it’s fun to inflict economic pain on 350 million people.
No, a recession is coming because 1) the Fed has only very limited, very blunt tools for fighting inflation, and 2) those tools aren’t very effective against the kind of inflation that is on the prowl in the current economy.
The Fed’s tool is interest rates (and other monetary moves that result in changes to the interest rate.)
Raise interest rates and credit gets more expensive and individuals buy fewer Teslas and mattresses and houses. That eventually results in demand destruction for electric cars and houses–and the things that go into them such as copper wiring, and lumber, and computer chips, and carpeting.
The housing market is one of the sensitive parts of the economy to a rise in interest rates and we can already see the effect of higher interest rates on demand in that sector: housing prices are still rising in many markets but the rate of increase has slowed and many economists think we’ll see new home prices fall in the next year.
We can construct a very simple mathematical expression for this process: Every X% increase in interest rates equals Y% demand destruction and Z% lower prices.
However, the relationship between X, Y, and Z isn’t the same in every economy.
And I’d argue that the Fed’s current problem is that given the structure of this economy and the source of higher prices, its’s going to take a lot more X% increase in interest rates to produce Y% demand destruction and Z% lower prices.
That’s because so much of current inflation is caused by a lack of supply resulting from war in Ukraine (higher wheat and energy price), from Covid-related turmoil in the supply chain (higher prices for chips and iPhones), from under-investment in factories and refineries, and from big disruptive weather events related to global warming.
That means the Fed will have to raise interest rates to a higher level in order to get a greater degree of demand destruction to generate the desired decline in prices (AKA inflation.)
Let me look at just one example.
In early May East coast inventories of diesel plunged to the lowest seasonal level since government records started more than 30 years ago. The shortage caused a crisis in the diesel market, sending wholesale and retail diesel prices to an all-time high. Diesel recently sold for close to $6 a gallon on the East Coast. That’s 75% higher than a year ago.
Diesel is today more expensive in America that it was in 2008, when the price of crude oil hit nearly $150 a barrel. West Texas Intermediate recently sold for $110 a barrel.
This is a big deal for inflation. Diesel is used everywhere in the global economy: trucks, tractors, freight trains and factories. Higher diesel prices mean higher prices for just about everything.
Why is there so little diesel in the oil tanks in New York harbor. Around the world, diesel is in short supply as demand has surged well above pre-Covid levels, spurred by a boom in freight (just in time global supply chains require a lot of diesel.) The Russian invasion of Ukraine has tightened flows further, as Washington has banned imports of Russian petroleum. At the same time, the U.S. has become the provider of last resort for many Latin American countries, with exports of gasoline, diesel and jet-fuel running at unusually high levels.
And, of course, there’s just this tiny little problem. In the past 15 years, the number of refineries on the U.S. East coast has halved to just seven. The closures have reduced the region’s oil processing capacity to just 818,000 barrels per day, down from 1.64 million barrels per day in 2009. Regional oil demand, however, is stronger.
So how do you cut the price of diesel and fight inflation?
The Fed can’t order the construction of new refineries (and forget about Congress or the White House doing anything.) The central bank has no influence on the war in Ukraine and global demand for diesel. It can’t set export policy. And it has no influencer on consumers in other countries and their demand for diesel.
The only thing it can do is push interest rates higher and hope that at some point that will reduce demand for the fuel–and lower prices for diesel and reduce the “diesel-inflation premium” in everything that travels by truck or rail or ship.
You can see how that might take a while and force the Fed to raise interest rates high enough to destroy more demand.
But the problem with diesel–and other commodities such as wheat–is that the commodity flow is hardly straight forward. There are all kinds of kinks and bottlenecks that give interest rates less power to reduce demand and to lower prices. For example, these me refineries are supposed to switch to producing gasoline for the summer driving season. Soon. And in the fall may consumers in the Northeast (and in some parts of Europe) will turn on heating systems powered by diesel fuel.
And there is some evidence that price elasticity for some goods and services has changed in the Post-Pandemic economy. Despite sky high gasoline prices everybody seems to be planning to travel this summer. Understandable. Everyone is tired of being locked up at home. But it also argues that high prices won’t immediately cut demand for many goods and services.
Which is bad news for a central bank looking to reduce inflation NOW.
