The effect could take two turns, depending on world events
by Tenpao Lee, Ph.D.Dr. Lee is an economist and professor emeritus at Niagara University. See his full BIO here.
As the consumer price index (CPI) was higher than expected in May due to inflation, the Fed has just announced an interest rate hike of .75 percent. The Fed will implement contractionary monetary policies by raising interest rates in the near future to fight inflation.
The effect of higher interest rates is to shift (lower) the aggregate demand curve to the left, as both consumer spending and company investments will be negatively affected by higher interest rates. As a result, both price and production quantity (GDP) will decline, ceteris paribus (holding all else equal).
Specifically, a decline of price means deflation while a decline of GDP means recession. Hence, there is a tradeoff between the macroeconomic goals of fighting inflation and recession avoidance.
A Matter Of Priorities…
Theoretically, we cannot have an optimal solution to deal with inflation and recession simultaneously. The government needs to set up its priorities to balance economic outcomes and inflation is the top priority for the time being.
Realistically, the economy is dynamic in nature which is determined by both aggregate supply and aggregate demand. The Fed’s contractionary monetary policy will mainly affect the aggregate demand and we need to assess the aggregate supply conditions to see if higher interest rates will be effective in fighting inflation.
So, what are the current aggregate supply conditions? There are two factors to consider: the pandemic (including the impact of lockdowns in China) and the Ukraine war. Both have affected aggregate supply, negatively for the time being. That is, the aggregate supply curve has shifted to the left, creating higher prices (inflation) and lower GDP (recession), ceteris paribus.
On the other hand, if the pandemic and the Ukraine war are contained, the aggregate supply curve would shift back to the right and create lower prices (deflation) and higher GDP (economic growth), ceteris paribus.
…And Supply & Demand
Let’s put both aggregate supply and aggregate demand together to figure out the “overall net effect” on inflation.
The common factor would be recession (lower aggregate demand- lower GDP- recession and lower aggregate supply- lower GDP- recession). Uncertainty would come from inflation (lower prices caused by the Fed and higher prices caused by the pandemic and the Ukraine war).
To conclude, if the shift of aggregate supply curve caused by the pandemic and the Ukraine war add up to more than the shift of aggregate demand curve caused by the Fed, the Fed’s contractionary monetary policies will not be effective and we will end up with inflation and recession, i.e. stagflation.
By the same token, if the pandemic and the Ukraine war are contained, the Fed’s contractionary monetary policies will be very effective in fighting inflation with minor or no recession, a soft landing for the economy.