The FED fails to control inflation. The long-term view

 In January 2022, we wrote in this blog about the strict proportionality between the CPI inflation and the actual interest rate defined by the Board of Governors of the Federal Reserve System, R. This previous post continued the thread of posts related to this issue. Briefly, the cumulative interest rate since the mid-50s is just the cumulative CPI times 1.37. Interestingly, there are periods when the interest rate deviates from the long-term inflation trend, which has been almost linear since 1972. Here, we extend the observational dataset to the period of the quickest inflation rise since the second part of 2021, and discuss the most probable reason why the FRS actually does not control inflation as such by presenting the actual economic force behind price inflation, as we described in a series of papers [e.g., 1, 2, 3, and 4].  Overall, inflation is a linear lagged function of the change in the labor force. The latter is driven by a secular change in the participation rate in the labor force (LFPR) together with a general increase in the working-age population. In other words, increasing the labor force pushes inflation up, and decreasing the labor force leads to price deflation. The period of the COVID-19 pandemic is the first one when helicopter money flooded the US economy and the inflation effect observed in 2021 and 2022 is fully explained by the natural dollar devaluation related to money excess (see this post).

Introducing new data obtained in 2022, we depict in Figure 1 the effective FED rate, R, and the CPI inflation as expressed in the relative growth rate (1/year). In Figure 2, R is divided by a factor of 1.37 (see our previous post for details) to match the long-term trend in consumer price inflation. Before 1980, R was rather in the leading position. Since the late 1970s, R lags behind the CPI, i.e. inflation grows at its own rate and R just follows. The sought level of price inflation was flexible. The idea of interest rate adjustment is that a higher R should suppress price inflation. During deflationary periods with a slow economy, low (in some countries negative) R has to channel cheap money into economic growth. The reaction of inflation is also expected not shortly but with some time lag.

Figure 1. The CPI inflation rate and the Federal Reserve effective rate, R.

Figure 2. The CPI inflation rate (monthly y/y CPI inflation rate) and the Federal Reserve effective rate, R, divided by 1.37 (R/1.37).

The cumulative influence of the interest rate should produce a desired effect in the long run, and inflation should go in the direction of acceptable values or target inflation. Figure 3 displays the cumulative effect, i.e. the cumulative values of the monthly estimates of R/1.37 and CPI. This is an intriguing plot. In the long run, the cumulative R/1.37 curve fluctuates around the CPI one and returns to it. It is hard to believe that the sign of deviation of R/1.37 from the CPI curve affects the behaviour of the CPI, which is practically linear. Therefore, the efficiency of monetary policy is in doubt. The FRS has tried all means to return the CPI to R without any success and has to return R/1.37 to the CPI!

Figure 3. The cumulative monthly values of R/1.37 and CPI since 1955. Vertical lines show the documented recessions in the USA.

Figure 4 shows the difference between the two cumulative curves in Figure 3 – CPI-R/1.37. One can observe a periodic character of the difference and unreasonably high correlation of the recessions with the peaks and kicks in the difference curve. Currently, the difference is close to the peak value observed in 1980. The recession observed in 2020 is likely related to the COVID-19 socio-economic collapse.  With the current high inflation and low R, a recession in the new future seems to be a highly likely event. The FED lost control of inflation despite their long-term task being extremely easy – just retain R at the level of 1.37CPI.  

Figure 4. The difference between the cumulative R/1.37 and CPI. Notice the correlation of the peaks and kicks in the difference curve and the US recessions.  

We will present the labor force and inflation relation in the second part of this post.