Raising interest rates will hit employment first

Stagflation is coming

The Fed’s decisions have an effect on the economy with some lag

The crisis will be in 2023.

Stagflation is an economic slowdown – stagnation while inflation continues to be high. Economists are worried about stagflation, writes Bill Connerly for Forbes.

As of June 2022, the United States is not in stagflation, nor is most of the world, but stagflation is probably coming.

The main reason for this is the effect of monetary policy. In short, actions by the Federal Reserve and other central banks affect employment before they affect inflation. Employment is already falling, but not inflation.

Tighter monetary policy limits the demand for goods and services. Higher interest rates discourage the purchase of expensive items. Interest rates affect household purchases of cars and homes. On the business side, capital expenditures and inventories are sensitive to higher interest rates.

The first effects of tightening monetary policy in the US are being felt in weaker sales on the business side.

Most companies will not initially know whether it is just their products or the entire economy that is suffering. But they hire less or stop hiring because they don’t need as many workers at a time when their sales are lower. They end up cutting hours for some workers and laying off others.

Prices react more slowly to the Federal Reserve’s interest rate decisions. Companies are initially hesitant to cut prices because their revenues are already lower due to the drop in sales. But some firms begin to cut prices to increase their market share, and eventually other companies follow suit.

The result of raising interest rates is that first employment shrinks and only later does inflation fall. Six months into the tightening of monetary policy in the US, half of the total hit to employment will have been felt, and the other half has yet to be felt. During this period, inflation continues to rise as rising interest rates drive up business costs. A year after tightening monetary policy, the effect on inflation will finally kick in. A year and a half after monetary policy tightening, the negative effects on employment will diminish, but inflation will still not be fully contained.

When will stagflation occur in the United States economy? The Fed implements its policy gradually, so any effects will be spread over a longer period of time, with little impact at first. The Fed first raised interest rates in March 2022 by a quarter point, followed in early May with a 0.5% increase, and then in mid-June with a 0.75% increase. These changes in interest rates were accompanied by changes in the securities held by the Fed.

The first increase will hardly be felt by employment and inflation. A rate hike in May will begin to slow employment growth in late summer. At this point, later changes in interest rates will have their first effects.

If inflation falls in 2022, it will not be due to monetary policy.

Stagflation will show early signs in late 2022 and flare up in 2023. By the end of this year, the risk of a recession will be much higher, although inflation will begin to decline.

These time lags should be viewed with some caution. Specific deadlines may change as the economy develops. But there will always be a time lag between changes in employment and changes in inflation, and this will cause stagflation every time the Federal Reserve tightens monetary policy in response to rising inflation.

Finally, let’s note that there are other things going on in addition to monetary policy. The war in Ukraine, supply chain issues, tax policy – all could have an impact on employment and inflation. But the bottom line is that stagflation is coming.

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