“Raising interest rates” is more complicated than you may think…

Elizabeth Warren proves you don’t truly understand what rising interest rates means for our economy… no one does.

In a congressional hearing, Senator Elizabeth Warren, in one of her infamous fiery questionings, drilled Jerome Powell, the head of the Federal Reserve.

I: 

“The feds are hiking up interest rates to stop inflation!” This eye-catching, hasty title is plastered across every major newspaper. Yet, these economic claims are followed up with little to no explanation. 

In a congressional hearing, Senator Elizabeth Warren, in one of her infamous fiery questionings, drilled Jerome Powell, the head of the Federal Reserve.

She asks him if gas prices or food prices will go down. To which he replies essentially that no, they will not. Sen. Warren expands “because rate hikes will not make Vladimir Putin turn his tanks around and leave Ukraine. right hikes will not break up monopolies, rate hikes will not straighten out the supply chain or speed up ships, or stop a virus that is still causing lockdowns in some parts of the world.” (Full video is attached above). 

Ok, so if not helping to decrease the price of food and oil, what does raising the interest rates do? Warren and Powell offer two drastically different answers. 

Powell explains:

“we think about interest rate increases as [effecting]... the economy through broad channels. The first of which is interest-sensitive spending, durable goods, automobiles, things like this. Interest rates go up, people’s demand for that as a result of interest rates will moderate or decline. The supply and demand can get a better balance. This second channel is just asset prices generally. Interest rates, as they go up, will cause asset prices to moderate across the economy. People spend a little bit less out of their lower level of wealth. The third channel is the exchange rate, which is really just another asset price. That is just basically... as rates go up, the dollar strengthens...”

While Warren refutes: 

“In effect, they [raising rates] cost to invest. To buy those trucks, new plants, to hire new people. The reason I am so concerned about this is rate increases make it more likely that companies will fire people and slash hours to shrink wage costs. Rate increases also make it more expensive for families to do things like borrow money for a house; so far, the cost this year of a mortgage has already doubled. Inflation is like an illness; the medicine needs to be tailored to the specific problem. Otherwise, you could make things a lot worse. Right now, the Fed has no control over the main drivers of rising prices. But, the Fed can slow demand but getting a lot of people fired and making families poorer. What president Biden is working to increase energy supplies, straighten that supply chain kinks, break up monopolies, bring down prices, you could actually tip this economy into recession. I just want to say, you know what is worse than high inflation and low unemployment? High inflation and a recession.

So, who is right? First, let’s investigate these claims more in-depth. 

II:

Let’s start with some Econ 101. The classic answer to “what does raising the interest rates do?” is that they help us decrease the money supply. The logic for this is simple. Interest rates are the amount you “pay” the bank for being allowed to use its money. The Fed loans money to banks, thus ultimately setting the national interest rate. If the interest rate is high, people are less incentivized to take loaned money, and the money supply goes down. Given that less than 10% of the money in circulation is actually cash (the rest being basically some form of a loan), this has a huge effect. 

(Here is where you can learn more about money being credit. And here is where you can learn more about the mechanisms the Fed uses to hike up interest rates.)

Ok, everything is good — we all agree… right? Well, not quite. We still have the fundamental question: why does this matter? How does this stop inflation and get our economy “back on track”?

The overly simplified explanation of this, which unfortunately is printed in a surprising number of newspapers, is that inflation happens when we print too much money, so having less money will decrease inflation. Inflation causes problems like increased prices and reduced purchasing power. So, by increasing the interest rate, inflation is stopped, prices go back to normal, and everything is solved! 

Yet, this is not quite right. Part of what I love about Waren’s line of questioning here is that she shoots a bullet into the heart of this lazy explanation: the Fed admits “decreasing the money supply” will NOT decrease gas prices or food prices in the short term.

Clearly, something is wrong with our over simplified explanation. 

III:

To understand this, we need to truly understand inflation. (Back to Econ 101).

This is easiest to understand inflation is on a micro-level. From a supply and demand perspective: “how much are people willing to spend on good X?” (How much money do they have access to? How much money could they get?) vs. “how of good x much can the producer make? At what price?” (Are supply or labor shortages present?). If people have more money and want more goods, but there are not enough goods that cost more to make, then the cost of the goods goes up: this is inflation. 

What causes inflation?

As Investopedia explains:

“There are four main drivers behind inflation. Among them are cost-push inflation, or the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, and demand-pull inflation, or the increase in aggregate demand, categorized by the four sections of the macroeconomy: households, business, governments, and foreign buyers. The two other contributing factors to inflation include an increase in the money supply of an economy and a decrease in the demand for money [I have often seen the last two grouped together into simply “monetary inflation”].”

Our economy has had all of these contribute to inflation increases. Cost-push: prices went up due to the Ukrainian war and higher labor costs. Demand-pull: people just got out of quarantine and wanted to spend money, and stimulus checks allowed them to spend more than usual. Monetary: Stimulus money, government debt, relatively low-interest rates, and high desire for loans/capital to purchase houses. 

IV:

Gas and food are being primarily driven up because of cost-push inflation. These goods are increasing in price because they are more expensive to make, and there are fewer of them. (The Ukrainian war, in large part, contributes to this). Additionally, these are inelastic goods: mainly, people will consume the same amount of food or gas no matter the price. 

Let’s look at the direct short-term effects of rising interest rates and see how they affect food and gas prices. 1) There is no clear mechanism for how rising interest rates could affect the supply in the short term. 2) Raising interest rates does not truly affect people’s need for gas and food in the short term. 3) Since most people do not use government money to finance their food or gas, rising interest rates do not directly affect the consumption of these goods. 

It is not as if as soon as there is “less money” in the market, I buy less gas, or there is suddenly more gas to buy. 

So is Warren right? Is raising interest rates entirely useless? Not quite. 

The trick is that raising interest rates operates through more complex and long-term mechanisms. It is not a simple equation where less money in the market leads to lower prices. 

V:

Let’s look at what interest rates actually do. Powell breaks this down into three main mechanisms. 

Firstly, “the first of which is interest-sensitive spending, durable goods, automobiles, things like this. Interest rates go up, people’s demand for that as a result of interest rates will moderate or decline. The supply and demand can get a better balance.”

Currently, 85% of all new car purchases are bought using credit. This means that the interest rate directly affects these purchases: if the interest rates go up, people must quite literally spend more money to purchase these goods. It is suddenly less cost-effective to buy these goods now than in the future or past when interest rates were lower. 

Although families may not have much flexibility in buying things like food or gas to get to work, more significant, less necessary, longer-term purchases have more flexibility. So, as a purchase price increases, demand drops significantly. 

Although this is one sector of the economy, Powell is hoping that it has a ripple effect. Since people’s demand for goods seems to remain abnormally high, the current labor and material shortages and the ensuing incredibly high cost of production lead to increasing prices across the economy. 

Hopefully, regulating demand in this sector of the economy will free up labor and materials for other areas of the economy, and “supply and demand can get a better balance.”

Secondly, “asset prices generally. Interest rates, as they go up, will cause asset prices to moderate across the economy. people spend a little bit less out of their lower level of wealth.”

Asset prices are also a function of supply and demand. How many people want/can afford a house? And how many assets are there? 

Currently, house prices are through the roof (They increased 11% in 2020 and 16% in 2021). Furthermore, the increasing prices of assets in turn cause more speculative asset buying. Since houses are bought using interest, these assets are directly more expensive. As this happens, hopefully, demand will temper, and the overall price of homes will drop. 

The third channel is the most complicated: “the exchange rate, which is really just another asset price. That is just basically… as rates go up, the dollar strengthens….”

A strong dollar is not always good.

“Other things equal, a stronger dollar makes U.S. goods relatively more expensive for foreigners, which benefits U.S. consumers of foreign goods (imports) and hurts American exporters and American firms that might not export but do compete with imports. In addition, a weaker dollar makes foreign goods (imports) relatively more expensive for American consumers, which benefits exporters of U.S. goods and American firms that compete with imports.”

Powell hopes that, given the U.S. is not exporting right now (as there are already enough shortages in the U.S.), we should shift our economy to be more favorable to imports. Rising interest rates will make dollars more valuable (you can get more returns/interest on our dollars), and thus, they will be worth more. As a result, foreign goods will be cheaper to import. 

The concern is that U.S. exports become more expensive(since they have to be paid for in dollars), and thus, economic activity slows, and U.S. labor becomes less valuable. 

Together, Powell explains, spending at large will drop, labor costs will fall, and inflation will slow. 

VI:

So, does Powell “win”? Is Warren just unilaterally wrong? Again, not quite.

 In this clip, whether they know it or not, Warren and Powell disagree on far more than the effects of interest rates: they have an ideological conflict on how the economy works. 

Powell fears that high inflation will hurt our economy and put us in a recession. Price increases will essentially devalue the currency and cause a spending spree. Additionally, it could lead to other countries no longer loaning the U.S. money since, as the dollar drops in value, their payment is now devalued. 

Warren, on the other hand, quite likes the idea that current assets are devalued. This leaves people with savings with less money, hypothetically closing the gap caused by accumulated wealth. Furthermore, as demand spikes, labor (and manufacturing) has relatively more power, leading to wage increases. Essentially, she believes that over time the wage increases will balance out the price increases, and the only effect will be decreased asset value. (Whether this is true is debatable… (Here). 

Both of these positions are complex subjects that I will leave for another article. But, I think it is helpful to look towards an example. In the 1980s, inflation was similarly high. The U.S. was afraid of having hyperinflation, like in the Weimar Republic. “The U.S. is nowhere near this situation, but central banks like the Federal Reserve want to avoid it at all costs, so they typically step in to try to reduce inflation before it gets out of control.

The problem is the primary way it does that is by raising interest rates, which slows the economy. If the Fed is forced to raise interest rates too quickly, it can cause a recession and result in higher unemployment – as the U.S. experienced in the early 1980s, around the last time inflation was this high. Then-Fed chair Paul Volcker did manage to rein in inflation from as high as about 14% in 1980 – at the cost of double-digit unemployment rates.”

The debate remains as to whether raising interest rates was necessary to stop inflation and a more significant recession or actually caused the recession. 

The point remains that this situation is much much more complicated than the media makes it out to be. And for all of her flaws, we can thank Elizabeth Warren for pointing this out.