What Did The Fed Do Wrong? – OpEd


By Kung Chan

A ground service agent named Richard Russell stole a plane from Seattle-Tacoma International Airport, took it to the sky, and died by intentionally crashing the aircraft on lightly populated Ketron Island in Puget Sound. Just before he did that, countless pilots listened to his gentle voice as he shared his despair through the radio. Like many in the service industry, he worked tirelessly in a mundane job, often enduring the pressures of supervisors and the stress of low wages. In reality, he harbored a childhood dream of flying, one that would be forever unattainable. He was a smart individual but plagued by profound hopelessness.

The despair experienced by people like Russell is not without reason. Despite rising incomes, they find it increasingly difficult to keep pace with the soaring cost of living.

After the COVID-19 pandemic, car prices remained high, defying the expectations that there would be a significant drop. In the United States, some luxury SUV models, previously priced at just over USD 40,000, now easily fetch more than USD 70,000 or even higher with minimal alterations. While global automakers used to attribute these price hikes to dealerships, they no longer shy away from admitting that they are raising prices across various vehicle categories. Consequently, American consumers can only reminisce about the days when affordable, budget-friendly cars.

Among the service industry, the cost of higher education in the U.S. continues to skyrocket, with no end in sight. Students attending slightly prestigious private American universities now face annual tuition fees of around USD 80,000, a cost that many middle-class families simply cannot bear. Insurance premiums are also on a relentless upward trajectory, consuming a significant portion of middle-class household incomes. This year, insurance expenses are projected to increase by 5% to 10%. The rising premiums not only affect individual residents but also have a substantial impact on corporate costs. Data from American insurance companies like Aon and Willis Towers Watson indicate that inflation in the American healthcare sector has become rather severe, potentially resulting in a 5.4% to 8.5% increase in medical costs for American employers by 2024.

In the present-day U.S., although President Joe Biden’s administration has issued more checks bearing his signature to the American people, there is a widespread feeling that prices are still generally too high relative to household income. Why are prices high? This is all due to the high-interest rates. Interest rates constitute the cost of capital, and this cost significantly influences the prices of goods and services. Therefore, with the Federal Reserve continuously raising interest rates, for ordinary individuals, the prices of everything will only continue to rise, rather than fall. This leads to a more painful, rather than improved, quality of life.

Why does the Fed keep raising the interest rates?

The decision to raise interest rates, in fact, is because the Fed sees inflation indicators as the standard for rate hikes. According to the key inflation indicator released by the Fed, inflation is expected to drop to 3.3% by the end of this year and further decrease to 2.5% next year. Returning to the Fed’s target inflation level of 2% is not expected until 2026. In other words, based on the current monetary policy, Americans in these coming years will not have the chance to witness an end to rate hikes or a start of rate reductions. Prices in daily life will continue to soar. It is reported that after the September interest rate meeting, 12 out of 19 voting members of the Fed believe that rate hikes will continue for the remainder of this year.

A paradox has thus emerged. The monetary policy aims to raise interest rates to curb inflation, but in practice, these rate hikes are causing inflation instead, leading to new hardships in people’s lives. What exactly has gone wrong in the monetary policy logic in this situation?

The real issue is that the Fed is attempting to address current problems with old-school, academically oriented-financial thinking. If inflation rates well above 2% were occurring in a relatively stable environment, as was the case in the late 20th century during the era of globalization, then such monetary policy, including raising interest rates, would be considered reasonable. During that period, price fluctuations were largely dependent on monetary factors. Due to the sensitivity to monetary policy, it could play a crucial role.

Yet things have changed considerably now.

The world is now witnessing a shift towards deglobalization. American industries and businesses are resetting their supply chains, and even relocating their production facilities. In the past, production was heavily concentrated in China, often dubbed the “world’s factory” back then. Now, resources are spread across diverse locations like Vietnam, India, Bangladesh, and Indonesia. This leads to variations in product quality, differing standards and costs, as well as a range of transportation logistics. Consequently, fluctuations in inventory levels lead to increased costs, rather than reductions. These challenges are a direct result of the deglobalization trend and the reconfiguration of supply chains.

It should be noted that the Fed’s mistake is that the costs generated by deglobalization and supply chain reset are rigid, and they cannot be addressed by the monetary policy of interest rate adjustments. If the Fed’s initial inflation target was 2%, then in the context of deglobalization and supply chain reset, the Fed’s inflation target should be 4%. Half of this inflation is due to deglobalization and supply chain reset and cannot be adjusted by a monetary policy that focuses on raising interest rates. Therefore, such a rate hike should be the correct direction for the Fed. Excessive intervention will only lead to more market distortions.

What would happen then, if the Fed persists in raising interest rates?

This would be a very perilous monetary strategy. Under the circumstances in which raising interest rates would not affect the price hikes caused by the supply chain reset, it could very well affect businesses’ survival, as well as consumption. In such a scenario, the Fed’s commitment to raising rates might very well lead to stagflation in the U.S., where the economy stalls amid inflation. Politically, this would seriously impact the fortunes of the Democrat government, as rising unemployment tends to incite widespread anger. Economically, no one benefits from it. With the turmoil in economic, financial, and industrial orders, this could potentially trigger a string of financial institution bankruptcies.

On October 2, during a meeting, Fed Chairman Jerome Powell made a side visit to York in Pennsylvania. where he visited the local open-air market and a coffee shop, attempting to engage with the locals. However, in this brief excursion, Powell faced the ire of several vendors. “We were a little blind-sided by inflation,” a business owner by the name of Julie Flinchbaugh Keene complained, “predictability is just gone. It’s very hard to operate a business without predictability”. When Powell inquired about the specific difficulties they encountered, Keene pointed out that “fuel costs, fertilizer prices, and wages” were all a “concern”.

According to the Washington Post’s report, Cindy Steele, chief operating officer at Central Market, a facility for smaller retail vendors, told the Fed officials that “I think our biggest problem for vendors right now is staffing”, and she pointed out that even if she could find staff, they do not last. Jennifer Heasley, an owner of a sauce shop, said in an interview that high-interest rates were a problem for her business, and now the interest rate on her credit card repayments exceeds 8%. Because of this, profit margins have dropped on her sauces, forcing her to raise prices. Of course, there are many other complaints. Powell’s mood in his excursion must have been affected by such complaints.

It is evident that the larger problems resulting from the Fed’s mistakes are still looming. The latest news is that a bank executive at Wells Fargo, a major U.S. bank, committed suicide by jumping off a building due to overwhelming stress.

Kung Chan is a researcher at ANBOUND

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