The rule is that inflation results when demand overtakes supply. No one disputes that the current inflationary episode is following the rule–at least as to goods. The debate is whether demand in the aggregate (i.e., for both goods and services) is too high, and should be reduced by interest rate hikes, or whether demand for goods has been increased artificially by the pandemic at the expense of services, in which case interest rate hikes will do nothing but punish the markets. Paul Krugman appropriately calls adherents of the first opinion “Overheaters” and the second opinion “Skewers.” Who is correct here?
Based on GDP data and inflation rates in comparable countries, 5 percent of our 7 percent inflation rate is caused by “skewing,” and the remainder by “overheating.” This means only a small portion of the inflation rate can be addressed through interest rate increases. In addition, much of the heightened demand for goods is being financed by pandemic savings, not by borrowing; increasing interest rates won’t solve that problem, either.
The bottom line is that the Fed can do a lot of collateral damage to the economy by raising rates sharply, but it cannot address the root cause of most of the inflation–the pandemic. Increasing rates to their pre-pandemic level is appropriate, as the economy no longer needs extra fuel to burn, but it would be a mistake to do anything more than that.