Interest Rates, Inflation, and the Economy

I'm getting very worried about the economy. In the past year or so the cost of energy has jumped quite a bit (no, really), upsetting the balance of many budgets.

The jump is severe enough that something has to be done to bring the overall budget back into line. The something, for companies, is to raise prices. The something, for laborers, is to ask for a pay raise, which will, of course, require employers to raise prices a bit more.

Some employers have other options, like investing in technology to boost productivity. But that often requires borrowing money and this is where the Fed comes in as the managers of interest rates.

To be fair, what the Fed manages is actually just the interest rate used by banks borrowing money overnight (or something like that). But this rate trickles down (isn't that a Laffer?) to other rates, including home mortgages, home improvement loans, and business loans.

The Fed adjusts this key interest rate as a control on inflation. They raise it to stop inflation and lower it to spur business growth.

So the business that wants to invest in technology to use in the US may find itself having to pay higher interest rates because the Fed wants to prevent inflation.

Do you see the conflict yet? In order to avoid raising prices (inflation) a company wants to invest in technology that will boost productivity, but can't because they can't afford the interest rates that the Fed is jacking up.

So what happens? Well, for some companies they are now forced to another option: off-shoring. Yep, you can invest in new technology in another country for less money (especially when factoring in the lower labor costs over there).

Good-bye jobs. Good-bye middle class. Thanks a lot, Fed.

I would argue instead that inflation can be a good thing in limited quantities. For example, the government isn't upset about inflation of 2 to 3 percent. I would also suggest that inflation which simply brings the cost of energy back into line isn't a problem either.

To be sure, inflation is hard for those on fixed or very low incomes. But since the government has a pretty good grasp on those they can be dealt with: Raise the minimum wage; raise benefits for entitlement programs (e.g. social security, welfare, etc.).

So long as inflation is simply to address rebalancing, it shouldn't be a disaster. And I fear that the alternative will be worse as the economy grinds to a screeching halt.

I am reminded of the axiom which says that everything looks like a nail if your only tool is a hammer. The Fed needs some vision correction.