Monetary policy can’t effectively contain inflation

Today, the Fed’s Dual Mandate is interpreted as an inflation target. The Fed—and other central bankers—seek to keep inflation at 2%. Inflation is defined as the general change in the price of some basket of goods and services. Which goods, which services, and in what quantities are constantly debated. Each market participant and economist has his/her preferred metric, be it the Consumer Price Index (CPI), Personal Consumption Expenditures Price Index (PCE), CPI excluding food and energy, core PCE, the price of gold, etc. Importantly, inflation no longer stands for monetary debasement (as there are no monetary standards to debase in fiat currency regimes; more on that here). Thus, inflation is subjective. Its presence, amount, and scope are constantly disputed. What’s not contested is how the Fed achieves its target. It’s widely held that adjusting the Federal Funds Rate (FFR) does the trick. "The orthodoxy guiding policy in the post-WWII era was Keynesian stabilization policy, motivated in large part by the painful memory of the unprecedented high unemployment in the United States and around the world during the 1930s. The focal point of these policies was the management of aggregate spending (demand) by way of the spending and taxation policies of the fiscal authority and the monetary policies of the central bank. The idea that monetary policy can and should be used to manage aggregate spending and stabilize economic activity is still a generally accepted tenet that guides the policies of the Federal Reserve and other central banks today." According to this Keynesian stance, which most academics support, the Fed impacts demand by adjusting the FFR. Raising it can “cool down” an overheated economy while lowering the FFR can stimulate an under-utilized one. Without getting into the details, the theory rests on the Taylor Rule, which links interest rates to levels of aggregate demand. As described below: "The theory …is based on the view that the economy can move above or below a full market-clearing equilibrium in the short run—called a “demand gap.” A positive demand gap means the economy is overheated; a negative demand gap means it is operating below capacity. Other than random shocks, the main disturbance preventing general equilibrium is a deviation of the real interest rate from the natural interest rate. The policy solution is to adjust the nominal fed funds rate to move the real rate to the natural rate. … Instead of using money supply as a policy tool, the Fed follows a Taylor rule in setting the fed funds rate target. To the extent that it can align inflation expectations with its own ultimate inflation target, the Fed is able to get actual inflation in its target range (typically close to a measured 2 percent rate)." This theory drives the Fed. It primarily conducts monetary policy by adjusting the FFR to achieve a 2% inflation rate. The Fed believes that changing the FFR impacts the overall level of demand for goods and services in the United States. According to the law of supply and demand, lower demand should lead to lower prices—on average—and vice versa. It’s a neat little theory. "Well, so, as I mentioned, you can see places where the demand is substantially in excess of supply. And what you’re seeing as a result of that is prices going up and at unsustainable levels, levels that are not consistent with 2 percent inflation. And so what our tools do is that as we raise interest rates, demand moderates: it moves down. Interest rates, you know—businesses will invest a little bit less, consumers will spend a little bit less. That’s how it works. But, ultimately, getting those, getting supply and demand back, you know, back in balance, is what gives us 2 percent inflation, which is what gives the economy a footing where people can lead successful economic lives and not worry about inflation." While orthodoxy today, some economists note that the “empirical evidence for this [theory linking interest rates to demand] is surprisingly weak … .” Interest rates simply don’t impact commercial investment and consumer spending as theorized. Thus, the interest rates-inflation link seems more myth than science. Yet this theory drives monetary policy globally. "The theory is that as interest rates rise, borrowers decide to borrow and spend less. The empirical evidence for this is surprisingly weak, for the most part. Empirical estimates of the elasticity of spending with respect to the interest rate generally show it does not matter much—with the exception of purchases of residential real estate. Low rates probably boost asset markets (including housing), but that does not feed directly into inflation." As an investor closely following individual companies for nearly 20 years, I’ve always found this popular theory bizarre. Prices are not a plaything for academics or central planners. They play a specific and vital role in commerce. By utilizing the language of money, prices mark the value at which items trade. As a result, they facilitate the movement of value from producer to consumer. It should be obvious that prices are not set from the top down. Rather, each business (and individual) engaged in trade meticulously derives them one by one. The goal, however, is not to maximize prices. Businesses seek to maximize profits. Prices are just a means to a business’s end. Profit maximization is not an abstract concept or “something nice to have.” It is a matter of survival. Each business consumes resources in order to create higher-value ones. Every input, from energy, labor, unfinished goods, websites, real estate, and financing, must first be acquired and organized before they can be transformed into output sold to others. Profit measures the value produced in this process. A loss represents a net consumption of resources. Thus, a money-losing entity cannot survive on its own. It consumes more than it produces and ultimately must perish (unless injected with fresh, outside capital). “I have to raise prices when I raise wages. That’s just how it works,” said Herridge, who doesn’t have enough staff to get all of his Burger King locations back to 24-hour operations. “That’s going to be the primary driver of inflation still over the next year or so.” Unsurprisingly, businesses respond to rising input costs by raising prices. Their revenues must keep up. Failure results in hardship and, potentially, catastrophic failure. Look no further than your local gas station. When the price of (crude) oil increases, so does gasoline at the pump. The gas station does not concern itself with a drop in demand (at least initially). It’s focused on survival. The same holds for every item. Gasoline prices are tightly correlated with the price of crude oil from which it’s derived. Contrary to theory, the Fed is forcing businesses to raise prices by hiking the FFR, both directly and indirectly. Higher interest rates lead to higher financing costs which must be paid for with revenue. While not all companies employ debt, all consume capital. Thus, raising the cost of capital impacts all commercial ventures to varying degrees.