Why inflation is likely to remain sky high

(Conversation) – Rapid inflation this is the main problem for many midterm voters, most of whom are Republican would do a better job solving the problem.

Indeed, the Republican candidates are taking full advantage of voters’ concerns about inflation pushing Democrats on the issue and promoting their own anti-inflation ideas such as cutting government spending and taxes.

How expert in finance and economics, I studied inflation, what causes it and what can reduce it. This is why I doubt a Republican Congress would have much of an impact on inflation, if any at all.

Two drivers of inflation

Inflation, or the steady rise in consumer prices, is created in two main ways.

The first is by increasing the demand for products and services. For example, at the beginning of the pandemic the demand for webcams has increased dramatically, as many employees had to work remotely. As a result, prices for webcams have risen significantly.

Or take tourist trips, the number of which has increased significantly as the spread of COVID-19 has subsided. People fly more which led to higher ticket prices.

When these types of demand-driven price increases occur for a large number of products and services, the result is rising inflation.

Inflation can also result from rising production costs.

For example, gas prices are rising because it has become much more expensive to extract it. War in Ukraine caused a sharp rise in oil prices in early 2022. They have declined, but recent supply cuts by OPEC+ oil producers caused another surge. When oil prices rise, higher costs are passed on to refiners, leading to higher prices at the pump.

Another example of such inflation is the increase in the price of eggs. The cause of death was bird flu about 10% of laying hens beginning of January 2022. In addition, farmers faced higher fuel and fertilizer costs. These factors determined the average price of eggs soar to an all-time high.

The Fed can only deal with half the battle

An economy’s central bank, not Congress or the president, is usually the first line of defense when it comes to fighting inflation. Central banks set monetary policy, and their primary way of dealing with inflation is by raising interest rates.

In the US, the Federal Reserve System focuses on the so-called federal funds rate, which is the base rate that banks use to set their own deposit and loan rates. Fed in 2022 increased this indicator five timesfrom around 0% in March to 3% – and rates are expected to rise by another 0.75 percentage point on November 2, 2022.

The primary purpose of rate hikes is to increase borrowing costs and thus reduce demand – the first factor in inflation I noted above. The idea is that higher interest rates cause people and businesses to borrow less. The less people and businesses borrow, the less they will spend.

The impact of rising interest rates is already being felt, for example, in the housing market. Current 30-year mortgage rates average over 7%, more than double from a year ago and the highest since 2002. This leads to fewer home sales and falling prices.

The problem is that this approach has absolutely no effect on the other main generator of inflation — the increase in the cost of production.

Higher Fed rates won’t stop the war in Ukraine or make the chickens lay more eggs. Therefore, energy and egg prices will not decrease as a result. This is also true for all products and services whose production costs rise due to supply chain issues.

These problems affected the prices of everything from bicycles to toilet paper. Higher interest rates will have no effect on demand and thus on prices for bicycles, toilet paper, or any other commodity that experiences supply chain stress.

Congress’s fiscal tools are also limited

Congress and the White House do have some tools they can use to fight inflation. One problem is that they are not very popular and so hard to pass. Another is that, like the Fed’s rate hikes, they target only one type of inflation.

The main thing a government can do is take money out of the pockets of consumers and businesses by raising taxes or cutting spending — or both. Reduction of money in the economy leads to a decrease in demand for goods and services, both the government spends less and individuals and businesses give more or receive less from the government.

But, as with higher rates, it will do nothing to solve the current supply chain problems in the global economy or reduce the cost of production. Changes in taxes or government spending won’t lower food prices or the cost of heating your home this winter.

So even though a Republican Congress might want to do more about inflation, whatever it does will only affect one factor.

Who is better off from inflation

Taking a step back, does any political party have a better track record of dealing with inflation?

The short answer is no. based on my analysis economic data from 1953 to 2020. From Presidents Dwight D. Eisenhower to Donald Trump, inflation averaged 3.35% under democratic administrations and 3.5% under republican ones.

However, there is one caveat. When the House and Senate are controlled by Republicans and the president is a Democrat, inflation was on average 2 percentage points lower than when it was all in Democratic hands. There is less data, so this is not a strong conclusion, but it does suggest that there are advantages to a divided government.

Another way to look at this is to examine current or proposed party policies. Democrats have been touting their “Low Inflation Act,” a package of climate, health care and tax measures passed in August, as proof that they are solving the problem. But despite the name, economists expect it to have very little impact on inflation in the near term because most of the measures take years to come into effect.

Republicans, meanwhile, proposed to cut costs – for example, on America’s social safety net – and tax cuts for wealthier people and businesses. While spending cuts would reduce demand – and inflation – lower taxes would do the opposite and push up prices, injecting more money into the economy.

In other words, expect inflation to remain high regardless of which political party holds the majority in the House and Senate. And then back to the hope — that the Fed’s rate hikes will work and the supply chain problems that are driving up costs will begin to ease.