This week the Federal Reserve again raised the discount rate a steep .75 percent. This is the rate the Federal Reserve charges to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility. This increased the discount rate to around 3.25 percent when it had been near zero as late as March. This effectively raises the interest rates throughout the economy with mortgage interest rates now over 6 percent when they had been under 3 percent just a few months ago. This tends to have the effect of hurting businesses and contracting the economy including raising unemployment and this is exactly what the Federal Reserve is trying to accomplish to help combat inflation. The thinking goes that if you contract the economy and throw people out of work there will be less profits and wages available to demand goods and services and thus prices will fall lowering inflation. The Federal Reserve attempts to work from the demand side to control inflation. However, they do not properly consider the supply side as though demand might go down the contracting economy will also produce less supply of goods and services to demand negating the effect on inflation and harming many businesses and people thrown out of work.
Actually, inflation is caused primarily by the money supply being increased without a corresponding growth in the economy producing goods and services for the additional printed money to buy, thus causing inflation. With the government increasing spending by trillions the last couple of years including for stimulus handouts an incredible 13 trillion or so new dollars have been printed and the economy has not grown nearly sufficient enough to produce goods and services for these dollars to chase. Therefore, the extra dollars are left to chase the existing goods and services and drive prices up causing inflation. This is effectively a tax on everyone, including the poor, as the handouts and other deficit spending by the government have to be paid by someone in someway.
The Federal Reserve’s strategy to hurt the economy and throw people out or work is exactly the wrong way to combat inflation. We need policies that grow the economy as much as possible and restrain government spending to lower inflation. Further, the Federal Reserve should let the market determine the appropriate interest rates. By letting a council of men and women arbitrarily set rates simply sets up inequities by creating transfers of wealth from one group of people to another. The Federal Reserve until recently have been arbitrarily keeping interest rates very low which enriched the people in the stock market and the large corporate interests in particular but crushed those that depended on a reasonable interest rate on their savings to live. Now by raising rates so much and abruptly it is crushing the stock market and sending the country into recession.
We have a very complex economy and there are factors other than the money supply that can effect inflation in the short run to some degree such as some of the supply chain problems we have had recently which causes shortages of goods. However, fundamentally and long-term the money supply and excess government printing of dollars to fund excessive spending is the key to understanding inflation.