Paul Krugman is puzzled. Why haven’t the Fed’s interest rate increases significantly cooled aggregate demand? The answer is simple, and I’ve stated it many times before; demand is being fueled by pandemic savings and high stock and real estate prices, not by borrowed money. As a result, interest rate increases are largely irrelevant in the fight against inflation; they don’t account for the significant progress to date, and they won’t solve the problem in the future.
All the Fed can do is drive the construction industry to its knees, lower home prices, and damage the confidence of stock market investors, which would ultimately lead to reduced spending by affluent consumers. The problem is that the investors see the improved inflation data and think lower interest rates are on the way. As a result, the Fed has to sound hawkish even when the data don’t justify it. It’s a fairly ridiculous state of affairs.
If you really want to lower inflation to 2 percent, the best way to do it would be a tax increase on the affluent that would suck up the excess pandemic savings. That, of course, is completely off the table. What we are left with is an inflation-fighting mechanism that doesn’t really work. Does that make sense to you? Of course not.