Here's my try:
- Unlike popular perception, money is not created by "printing it". Money is created, or the supply of money is added to, when entities (corporations, institutions, people) borrow money from a bank.
- When interest rates go up, the cost of borrowing goes up because you have to pay back more over time.
- When the cost of borrowing goes up people borrow less.
- When their is less borrowing their is less money in the economy. Less of a currency trying to purchase the same amount of goods lowers prices.
Lots of companies make money from the cash flow spread between interest rates and whatever their investment is. And when interest rates rise, entire segments of their business become fundamentally unprofitable. It's not just banks either.
Say a company buys a $100k asset, and they can use it to generate $10k in revenue. That's a profitable investment at 5% interest ($5k), but not at 10% ($10k). So at high enough interest rates, it's not economically viable for that company to expand. That lack of expansion has upstream implications, and can have a cooling effect on asset prices at broad levels.
You can be stupid and talk about buying food and gas on credit cards. Very few people in this country will stop buying food and gas to prevent default. People need food and gas to survive. So it's not really the borrowed money that is spent on food and gas.
Oh, but people will stop buying so much food and gas, just not directly. Without enough money, some people will cancel their planned trip to Hawaii. That's a lot of gas not burning right there. Or they won't buy another TV, which needs gas to be delivered to your home. With less people competing for precious gas, its prices drop.
> Without enough money, some people will cancel their planned trip to Hawaii.
By this logic, why doesn't Congress illegalize travel? Is that going to reduce the cost of travel? Will that reduce CPI, which measures prices, not demand?
> Or they won't buy another TV,
What if we illegalized buying TVs? Would that make TV prices fall? You think that is going to reduce CPI?
I'm not saying your explanation here is stupid. It is the first one in a while that seems to at least appeal to common sense. I am just trying to show that CPI measures prices, it does not measure demand or supply alone for goods.
> With less people competing for precious gas, its prices drop.
Gas prices rise and fall all the time. Lots of factors go into its price. You could illegalize gas, would this cause the price of gas to rise or fall?
> > Without enough money, some people will cancel their planned trip to Hawaii.
> By this logic, why doesn't Congress illegalize travel? Is that going to reduce the cost of travel? Will that reduce CPI, which measures prices, not demand?
Hey, you asked for a "common sense explanation" how the policy works, and people gave it to you. If your intention was "I want to debate unrealistic what-ifs with as many people as possible," then you could have made yourself clear in the first question.
You’re talking on a micro level, the OP is talking about macro monetary theory. It’s not about individuals borrowing money, it’s about companies and banks borrowing money and how difficult that is. Monetary supply past m1 is produced by banks borrowing and lending money, and limiting that directly limits monetary supply.
If person A holds on to the borrowed cash and doesn't spend it, that money doesn't circulate (the velocity of money decreases).
If person A doesn't take the loan, there is less money in the system (money supply is reduced).
If there's less money circulating, people won't "bid-up" the prices of food and gas as much, reducing their price (assuming constant supply of food and gas).
Person B might not be able to afford the gas in food now so possibly. The main way it functions is ultimately depressing wages and putting people out of work so there's less demand.
More expensive credit to businesses leads to less investment and growth leading to less hiring leading to higher unemployment. Higher unemployment means some people won't be able to afford food and gas lowering the demand for food and gas.
That's the theory anyway, they don't say it in plain terms like that though.
Well the US isn't setup for it in most places but in larger cities it is possible although sometimes less convenient to take transit or bike, so I don't think people "need" gas to survive.
Even if you're not put fully out of work if you have less money you'll only take essential trips reducing gas demand even if you're somewhere without public transit at all. Same with food, less money means you'll buy cheaper alternatives that are generally easier to produce.
Just because something is 'essential' doesn't mean you'll always spend the same amount on it regardless of your economic situation.
The Fed's tools are very blunt, and the only way it can reduce at-the-register prices for things like food and gas are indeed by hammering down aggregate demand, i.e. inducing a recession.
Of course, whatever the Fed does may be counterbalanced by supply-side issues, whether economic or political; a warmer-than-expected winter moderating gas prices, or executive actions impeding investment into O&G raising prices, and so on; and other demand-side issues, such as more helicopter money sprayed against fixed supply.
> The Fed's tools are very blunt, and the only way it can reduce at-the-register prices for things like food and gas are indeed by hammering down aggregate demand, i.e. inducing a recession.
By some measures, it's not even succeeding in inducing a recession. Demand isn't even necessarily declining - you would need a common sense explanation why the rate of increase in demand doesn't sometimes fluctuate or go down anyway, in the absence of fed action.
The Fed's tools are extremely effective at taking a huge shit on bond prices. They have huge financial impacts. But you are not giving me a common sense explanation for how raising interest rates will reduce the prices of food and gas.
They're trying to reduce the rate of inflation, not "the price of food and gas". Depending on the measure of inflation you're using, food and gas might not even be in that measure.
> "I am once again asking for" a common sense explanation for how increasing interest rates will reduce the prices of retail food and gas.
It will not. The only way to reduce prices of oil/gas and fertilizers (for food) is to bring back the amount of oil/gas and ammonia that went offline due to Russia. There is no amount of digging anywhere in the world that will quickly replace this much lost natural resource.
What raising interest rates will do is cause less spending in all non-oil/gas goods and services. This means every other industry must expect a reduction in revenues because the average customer is going to be spending more on oil/gas and food.
In other words, the choices for companies are: be ok with reduced revenue or be ok with reducing prices.
The choices for individuals are: be ok with consuming less non-oil/gas/food things or sell assets to fund oil/gas/food things.
Oil isn't a serious problem, neither is gasoline. The West can safely maintain the situation with Russia indefinitely.
Brent has been in the $90s for a while now. That's equivalent to $65-$70 from ten years ago, which also wasn't a problem then. It's very modestly elevated at present.
Natural gas may be a different matter, although the Europeans look like they can have that permanently solved over the next few years through diversification and greater energy conservation.
You can't mention oil prices without mentioning the U.S. SPR (Strategic Petroleum Reserve) releases (around ~250M barrels released this year, around 1/3 of the total reserve):
Without those, the price of crude oil would likely be higher than it is at the moment (although hard to say how much higher). The fact that China is still pursuing a COVID-0 policy has also helped keep global demand depressed - but we can't rely on that indefinitely.
If it wasn't a problem, Biden wouldn't tour Iran, Venezuela and Saudi Arabia to get their oil and wouldn't open the national reserve. Nations literally live and die by the oil.
> The only way to reduce prices of oil/gas and fertilizers (for food) is to bring back the amount of oil/gas and ammonia that went offline due to Russia. There is no amount of digging anywhere in the world that will quickly replace this much lost natural resource.
At least this has a modicum of common sense to it.
As others have pointed out, oil prices fluctuate all the time though. So do food prices.
Gas can affect retail prices, because to me, common sense says, you use gas, not oil, to move food from wherever it is to the supermarket and into people's carts, back to their homes. And gas prices are not oil prices. And a lot of the price of many goods is, secretly, gas, because that is how the people get to where they work, how the goods that are otherwise useless without transportation get to where they're sold, etc.
> What raising interest rates will do is cause less spending in all non-oil/gas goods and services.
So what? The CPI, even the "core" CPI, is food and gas, or food and gas in disguise.
Even if you buy less clothing, a lot of the price of the clothes doesn't come from demand. It comes from the price of the gas used to move it from A to B and all the people involved moving it, and the price of the food to feed all the people who made it and sell it. Gas and food are hiding in all the inputs of clothes. There is a floor on the cost of clothes, it keeps rising, what exactly will increasing interest rates do to the rising (producer's) cost of clothes?
There is a floor to the cost of clothes. And at an extreme people will have to buy 2 t-shirts a year instead of 20. That means that tshirt producers will make less sales and go bust. The remaining few tshirt companies will bargain with all the suppliers to reduce their prices.
Families will have to go back to hand me downs, wearing the same shoes and socks for years.
The reality is that as long as so much of oil/gas inflation exists and interest rates rise, something other things will HAVE to give. People will just have to be ok with a life of less abundance.
1. choice: The idea is that you can put your money in the bank and get some interest or you can spend it. So when interest rates go up, people will chose to spend less and save more. Obviously rates have to be higher than inflation which is now 10%, for this strategy to work, but at high enough rates, they will choose to save rather then spend. Less spending, demand falls, so prices should drop.
2. money supply: For the non-financial sector of the economy, money is created when households borrow from banks, and money is destroyed when loans are repaid. Increasing interest rates reduces loan growth and thus the money supply. A smaller money supply should lead to lower prices.
3. business investment: higher interest rates means that the cost of capital to firms goes up. They must earn a higher margin in order to service whatever debt they have at the higher rates, and investors can choose to invest in the business or buy a bond, and so the business has to earn a return at least as high as the bond. So higher interest rates means that ventures which would have been profitable at a lower rate are no longer profitable. So less business investment at higher rates.
Reduce demand, broadly, as credit tightens with increased interest rates. Can't borrow at basically free money rates across the board anylonger.
Translates into, Less money for stock buybacks, less Yolo with stimy checks, left over money to yolo is also reduced == the market returns to mean. People feel less wealthy == slow purchases. Reduced purchases == Business struggle. Businesses lay people off == less demand. All of this == Less driving, less food.
That's not quite right, because if you only reduce demand you could also reduce supply and prices would be unchanged. Higher interest rates reduces money supply (which can induce a recession) but does not necessarily reduce the supply of goods. Less money chasing the same amount of goods (ideally) causes lower prices.
I don't think you are wrong intuitively. I am just trying to be a little more specific because get very vague about monetary policy and it leads to some bad assumptions.
> but does not necessarily reduce the supply of goods
Every mainstream economist agrees that rising interest rates increases unemployment.
Well you need human beings to go and make stuff like food and gas. That stuff is also already made as efficiently as possible. So supply is definitely, also, going to be reduced.
I think you are right, but keep in mind we are currently in the middle of raising interest rates and unemployment has not gone up. So what I am trying to say is, rather than say A (rising interest rates) -> D (recession), acknowledge what happens is A (rising interest rates) -> B (less money supply) -> C (less employment) -> D (recession)
Because if you don't acknowledge the steps, you can't explain what is happening today. Rates are going up and unemployment isn't. The economy is complicated.
They're increasing the cost of borrowing, which directly affects the cost of loan financing for something like a car or a house.
But probably more importantly the increased cost of borrowing hits businesses which are living on the edge and have been rolling over short term loans at low interest rates. When that debt service triples then those unprofitable businesses will start facing negative cash flow losses and can be pushed into insolvency.
For just one example, look at all the commercial real estate vacancies in downtown SF and Portland. Behind a lot of that will be very cheap financing which will go under when interest rates rise (and it is all reasonably short-term financing because it had to be in order to get the lowest interest rates and keep the businesses barely treading water -- so think of this as ARM mortgages for business).
So you have reduced demand for anything funded by loans, along with businesses at the margins going under because their cost of borrowing increases. You get layoffs from the businesses going under which will remove demand for goods. The reduced demands for goods then filters through the system producing more layoffs and more reduced demands for goods across every sector and the economy contracts into a recession.
All the Fed does is raise the cost of borrowing money which causes enough businesses on the edge of failure to fail that it pushes the economy into a recession--amplified by all the positive feedback loops in the economy.
Honestly don't know why this is such a mystery to everyone or why the question needs to be a "meme", it is pretty straightforwards. The only tricky part might be understanding why failures of businesses on the margins could lead to an economic collapse, but you'd think that with the audience of engineering-oriented people here that we'd collectively understand positive feedback loops amplifying small changes into big ones.
Oh there's also purely subjective psychological positive feedback loops as well. Layoffs at FAANGs right now (or whatever they're called these days) is more due to forward expectations and those businesses getting a bit more runway for the recession. But by doing that they're helping to create the very recession that they're getting prepared for. Similarly in the middle of a recession businesses cut jobs and curb spending because they're in a recession, making the recession worse.
> The reduced demands for goods then filters through the system producing more layoffs and more reduced demands for goods across every sector and the economy contracts into a recession.
Yes, but prices are not demand, they are supply and demand. What if you shut down the parts of the economy that make food and gas?
For example, how do fed interest rates shut down the parts of Saudi's economy that makes oil?
Anyway, in your explanation, you do not use the words "food" or "gas" which is how the "CPI" is calculated.
> Honestly don't know why this is such a mystery to everyone or why the question needs to be a "meme", it is pretty straightforwards.
Using the words in the question to answer the question is "straightforwards."
When people are fired from their jobs they no longer have money to spend, they don't take that trip to Disneyland this year (or whatever) and that shows up as reduced airline trips and miles driven, which impacts gas prices. Similarly because they're not buying as much consumer stuff that impacts deliveries. Businesses tighten spending which means less B2B stuff being bought which reduces manufacturing demand (and deliveries). That all drops demand for all kinds of energy and petroleum products.
I didn't mention the words "food" or "gas"[*] because I thought it was obvious, this stuff is really, really basic economics. The economy is all connected, so someone's contraction in spending is another market participant's contraction in demand--and as businesses see a contraction in their demand they adjust to contract their own spending.
When it comes to food, people contract their spending by starting to make coffee at home or just buy starbucks less often as a splurge rather than a daily thing, so that contracts revenue for starbucks, that leads to layoffs, which leads to less consumer spending, etc. The prices of staples don't usually drop as much because people still need to eat, but with reduced energy and transportation costs the supermarkets can reduce the cost of milk to try to attract customers.
[*] Actually on re-reading I did mention food and gas: "The reduced demands for goods then filters through the system producing more layoffs and more reduced demands for goods across every sector and the economy contracts into a recession." And "every sector" really means literally every sector of the economy--including "food and gas".
Lamontcg offered you the simple explanation of why interest rate management is used to manage inflation. They didn't muddy the waters by talking about market distortions and why it is best to minimalise these. They didn't go into an explanation of why interest rate hikes are themselves a marketplace intervention preventing the proper movement of debt pricing. They didn't even get lost in the labyrinth of exchange rates, and the impact all of this has upon a global trade currency.
Their explanation was about as simple as you can get.
> Yes, but prices are not demand, they are supply and demand. What if you shut down the parts of the economy that make food and gas?
Think this through and remember that food and fuel are must haves. There will always be demand, even at high prices. Just less of it. Which is what the point is.
I think a lot of people aren't approaching the problem correctly.
Prices going down (Deflation) in a modern economy is very very very bad even if it's for Food and Gas. Since WW2 our economic system has been based on prices going up because that means people are producing goods to make money to spend it on goods. The real goal of these interest rate is to slow the rate of price increase because now there is less money available to borrow / print into the system. People / Businesses will now use debt less often to leverage their purchases which will slow down the economy. If prices increase too quickly the system burns itself alive. If prices lower it decays and dies.
So to answer your question prices will continue to rise because inflation will remain positive, however the rate of it will be lower.
Economists have predicted "soft landings" before every recession I can remember where I've followed what the Fed has been saying (I don't quite remember the Volker Fed, I was a little too preoccupied with Star Wars toys and Legos).
And economists have predicted 9 of the last 5 recessions. And in an economy with 3.5% unemployment, the odds of a recession seem pretty low in my opinion.
We are pretty early into the cycle to declare such a thing. The rate increases are likely not close to ending. It takes time for this stuff to unwind.
Also note that we are in a similar situation as when Nixon propped up the economy before an election in 1972. It took a while for his policies to backfire. Unemployment rate was 3.5% when Nixon was elected and doubled by 1974.
The current dominating party in the US is not taking as many extreme measures as Nixon of course, but for me I want to see where the economy stands after the election dust has settled.
We are also pretty early into the cycle to declare that a recession is inevitable. Yet that's what a lot of people are saying. The only thing that can be said with certainty is that the future is risky and unclear. IOW, situation normal, all f^#$ed up.
It's not the election, it's Black Friday that will be the bellweather, I think. If inflation is still ongoing, discounts will be minimal. If the economy is going south, sales will be tepid. Nobody is ready to lower prices permanently, but temporarily? Massive discounts are the traditional way for retailers to lower prices in times of uncertainty. The rise of the dollar and the inflation of the past year will give retailers lots of room for discounts, so I expect to see them liberally applied. And with unemployment so low and low-income wages rising so quickly, I expect to see record retail spending this month.
The Fed is doing 0.75bp rate hikes every meeting and talking affectionately about Paul Volker. And Powell was pretty clearly saying that rates are going to go higher and stay higher longer than the market expects. We're going to have a recession.
This Black Friday is unlikely to be any kind of bellweather. It normally takes 6-12 months after rate hikes stop for them to be felt in the broader market. Next Black Friday might be a bellweather, but I expect that we'll already be in it by then.
Keep pushing out those goalposts. People on HN last spring were confident we'd be in a recession by now. Now you're saying that it's 6-12 months away? If you keep pushing those goalposts eventually you will be right. There will be a recession some time in the future.
Once the effects of the Fed rates hikes are felt broadly throughout the economy and unemployment is running closer to 8% let me know if that feels more like a recession or not.
They're not trying to reduce existing prices per se. They're trying to reduce the extent of price increases going forward.
The Fed can do that be damaging demand by damaging the labor market and reducing the value of assets (which also damages spending power ultimately in numerous ways).
There should be a lot more consideration given to increasing and improving on the production side right now, however the US is not nearly so skilled at that these days (whether industrially or policy wise). If you walk into your typical CVS or Walgreens and look at their empty baby formula section, it tells all. Supply chains are still a mess in the US.
Both groceries and gas are sold at low profit margins - I've heard as low as 1-2% for groceries. They are commodities, there's a lot of competition, and shoppers are very price conscious. If grocery stores can make a profit selling food cheaper they will. If grocery stores can pay less rent for their stores, pay less wages for their staff, pay less for all their expenses, those savings will get passed down to consumers as cheaper food.
I mean, when was the last time a company the size of a grocery store chain passed down savings to consumers? If anything, the pandemic has shown that companies will gladly continue to fleece customers despite lowering expenses. At the end of the day, they exist to extract as much profit as possible - if every one of their peers maintains high prices, consumers don't have any choice but to pay those prices.
It won't, because the current inflation is supplyside-driven, not expectations-driven. But if we transition to an expectations-driven inflation regime, that's really bad, because it would require much more severe action to bring under control. The Fed is doing this as a preventive measure to keep expectations-driven inflation from taking hold. It sucks, but it's being done to prevent more pain later.
I disagree. Supply constraints were a figment of unsustainable demand. There was simply too much money sloshing around to satisfy the hedonistic human treadmill of MORE!
> It won't, because the current inflation is supplyside-driven, not expectations-driven. But if we transition to an expectations-driven inflation regime, that's really bad, because it would require much more severe action to bring under control. The Fed is doing this as a preventive measure to keep expectations-driven inflation from taking hold. It sucks, but it's being done to prevent more pain later.
It won't necessary reduce the price of food or gas much (some nominal decrease from "discretionary," or non-essential, spending on both).
It will bring down housing, which is 1/3 of the CPI by weight and helps get the Fed's inflation metrics down. (Just as an example, it won't make as much sense to leverage up and buy 5 Airbnb's at higher interest rates.)
This is it. You trigger a pull back in the economy, if you get lucky you don't trigger a recession. But, if you need to trigger a recession you do it rather than out of control inflation.
Per other commenters less money in the economy reduces aggregate demand. Per previous inflationary periods where interest rates were raised basically by putting people out of work.
The idea is that people will cut spending somewhat to have more money stored in saving accounts where they produce more low-risk return. Cutting spending will dampen prices.
Increasing interest rates increases the temptation to lend money instead of spending.
Because people will cut spending on going to theaters somewhat, and that takes some gas to get there. No, short term people don't need theaters to survive.
There is some non-critical spending to cut, Feds rely on that.
Interest rates make things requiring financing (cars, homes, stuff bought on credit) more expensive and out of reach. People either buy less, or buy the same but pay more interest, meaning they have less money for the next purchase.
> Interest rates make things requiring financing (cars, homes, stuff bought on credit) more expensive and out of reach.
This is complex.
Lower interest rates overall increase home prices, because people buy the biggest home they can afford on a monthly payment.
There are many kinds of cars. Some are cheap and some are expensive.
Anyway, how do interest rates make things like food and gas more expensive and out of reach? Those don't require financing. They're hugely impactful on inflation. You can be the Fed, and pretend there's a "core" CPI, but the people who make your clothes and cars need food and gas, your clothes are made with a lot of gasoline directly, via shipping and manufacturing, etc., so it is sort of a fiction that there is this non-food-and-gas CPI.
It reduces demand - in the modern world the prices are disconnected from cost of production - instead reflect the demand for that product - how much can it be sold for
Does it suck money out of the system? Here's a common sense example: Raising interest rates caused assets like stocks and bonds to decline in price. People sell these equities and now have cash they are willing to spend on more shit, specifically what is in the CPI. So the opposite can also happen.
No it doesn't suck money out, but it reduces the rate at which new money is created through borrowing.
Every time a loan is agreed, the value of the ${NATIONAL_CURRENCY} is diluted by a tiny amount. And that tiny dilution is amplified through the economy and has a proportionally larger effect on the price of end-user items which inflate to compensate.
Increasing interest rates is not a lever that directly affects things measured by the CPI, but the idea is that the effects will ripple through the economy and reduce the delta-v of their prices at the end of a very complicated series of gears and pulleys.
It's a bit like trying to refloat a grounded ship by subtly nudging the Moon's orbit to modify the tides.
> No it doesn't suck money out, but it reduces the rate at which new money is created through borrowing.
This is true. It does not tell me how the money created through borrowing between 0.75% rates and 4.00% rates was used to buy food and gas though.
That borrowed money was overwhelming actually used to buy equities, which the fed is obviously impacting very effectively, and not food and gas, even indirectly.
They are not targeting retail food and gas specifically. The hope is that removing money from the economy will cause spending to slow down everywhere and that eventually will hit food.
Well, I don't see a common sense explanation as to why the rate of increase should decrease either. We could also say, "Eventually, the rate of increase will go down anyway, in the absence of any action from the fed."
I don't understand the entire system either, but one obvious effect is that there will be much less cash-out refinancing or flipping, which means at least that source of cash and the associated demand will get smaller. And judging how many people I know around town who have been treating their houses like ATMs, it's not a small effect.
> And judging how many people I know around town who have been treating their houses like ATMs, it's not a small effect.
This is true, this is at least appealing to common sense. But I don't see how that excess cash was going into spending more on food and gas.
If I run a supermarket and raise prices, and people like lettuce, if they keep buying the lettuce, because $3.75 lettuce is still worth it compared to $2.00 lettuce, well, CPI can increase a lot, and demand appears to be inelastic, and interest rate increases did nothing to reverse CPI.
TL;DR It puts people out of work so there's less demand and we move back down the demand/supply curve towards lower prices/slower increase in prices.
The simplistic version is one idea of the cause of inflation is there's too much demand for all goods as a whole in the economy because there's too much money floating around causing demand to push higher on the demand/supply curve because it's more expensive to produce more of something past a certain point. Making it harder to get loans decreases the money flowing in for some expenditures so there's less expansion in areas like hiring (which when we're near full employment like now usually means having to raise wages pushing costs up and injecting money into the more general market). Thus by increasing the cost of expansion you slow it down and cool the labor market and maybe even cause it to contract.
In the end it boils down to getting more people out of work so they can't buy as much and are willing to accept lower wages meaning it costs less to produce so you might meet the increased demand curve in the middle. It's an incredibly shaky way to try to run the economy but the government has limited knobs to turn and ideally it's easier to target relief at people put out of work because of this than it is to aid the entire population generally.
That's one theory I've heard explained at least. It's incredibly callous to me though because it depends on just putting people out of work and our safety nets in the US are extremely weak meaning you wind up with the fact that a 1 percentage point increase in the unemployment number is associated with a 1-1.6& increase in suicide rates. [0]
(This should be the new Deleuze meme.)