Interest Rate Policy vis a vis Inflation and Energy Costs

Some people talk of the Fed raising interest rates to combat inflation. That has me somewhat concerned. Let me start with the expression "when the only tool in your tool box is a hammer, all your problems look like nails." Controlling interest rates is one of the few economic tools in the Fed's toolbox. Let's examine that tool and the nail it is used for.

The typical model for inflation is that increased investment spending increases demand on resources. Excessive demand for resources presents upward pressure on prices due to simple supply and demand economics. This upward pressure on price is what ultimately manifests as inflation. Raising the interest rate serves to reduce demand for resources, and thus reduce inflationary price pressures, by making resources more expensive by the increased cost of money used to buy those resources. It should be noted that obviously real increased resource prices also serve to reduce demand by simple supply and demand market forces. The idea is to prevent real price increases by increasing the effective price when the cost of money is considered. So we should observe that both raising interest rates and the rising increase in the real cost of resources are both contractive economic influences but the latter has inflationary implications. The idea is to control inflation with a market mechanism we can control (interest rates) to throttle demand rather than allowing market forces to throttle demand via inflation. Interest rate control is a preventative measure to reduce real upward price pressures. Keep in mind that this tool only deal with domestic economic forces that we influence. Also keep in mind that with regard to interest rate policy, the converse is also true. That is, in an economy that is stagnant or contracting, reducing the interest rate is an expansionary influence by increasing investment spending by virtue of making the cost of money less expensive and thus the cost of buying resources less expensive. By simply market economics, the reduced cost drives up demand, which drives up supply, which expands the economy.

However, the problem we face is that the real price of energy is skyrocketing independent of domestic influences. Without getting too deep into global economics, the price of our domestic oil supply is being driven up by global influences which we have little control over. Oil is a global market and the global demand is increasing and driving up the price of oil which means that our domestic energy resource is becoming more costly. Of course the global oil market is fodder for entire dissertations in and off itself, so suffice it to say for the purposes here that domestically, the rising price of the resource of energy is a given. I'll touch on a little bit more on that later but first let's understand the nature of the problem.

The economy is exposed to pressures that are both inflationary and contractive by virtue of the increasing real price of the resource of energy. The question is that given we are dealing with the contractive influences of increased energy costs, why would we deploy the contractive influence of increased interest rates on top of that? Certainly this will have the effect of reducing the demand for energy, but since this is a global market over which we have only marginal influence, this is likely to have little effect on the cost of energy, which is a major driving force behind our economic problems. Decreasing our demand for oil will have downward price pressure on the cost of oil, but since we are only one player on the global energy market, that impact will likely be offset by increasing demand in countries such as China and India. The end result is that we would only marginally reduce inflation and the cost of oil, if at all, at the expense of an excessively shrunken economy. On the other hand, the contractive view of the problem would suggest lowering interest rates to spur expansion. However, this would obviously only increase the demand for already problematic energy resources.

Clearly the problem doesn't fit the model associated with the tool of interest rate control. Obviously if it's not a nail we're faced with, a hammer probably isn't going to be able to help. At this juncture there are really only two ways to deal with the economic impact of energy prices. We can figure out how to cope and deal with the higher cost of energy. We can buy smaller cars and use PT, like most other countries, and try to find more efficient ways to use energy that we do use so that we reduce cost by reducing how much we use. The other way is to reduce cost of energy by finding cost effective alternatives to dependence on the global oil market. This is by means of exploiting domestic oil sources and rational oil policies, exploiting alternate energy sources such as coal, nuclear, biofuels and fuels from waste and all of the conventional alternates with which we are already familiar, and developing new energy technologies and improving existing technologies. As I've said before, we need to actively pursue ALL of our options.