Imagine you are chairman of the Federal Reserve. If you want to increase the output of goods and services for the economy to lower prices by meeting elevated demand, what do you do? First, you beg off by saying the Fed doesn’t have any control over supply. Then you try to kill demand.
This is what Jerome Powell finds himself doing now, with inflation at 8.6%, a 40-year high. It almost sounds like the responsible course of action when Mr. Powell says: “We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.” But does it actually make sense to hike interest rates in a deliberate effort to reduce employment and curtail economic growth, all to relieve price pressures?
The Keynesian logic that underlies the Fed’s analytical framework is fairly straightforward. To stimulate economic activity and lift aggregate demand, the Fed engages in expansionary monetary policy: It lowers interest rates to encourage borrowing. When spending on goods and services outstrips production, causing inflation, the Fed uses contractionary monetary policy to dampen economic activity and reduce demand: It raises interest rates to discourage borrowing.