Real v. Monetary Inflation

A recent headline noted that the Fed is considering raising interest rates to fight inflation.

Spoiler alert: It won't work.

Usually, inflation is due to the money supply expanding faster than the pool of goods and services out there to spend money on. And when that is the case, raising interest rates can tame inflation.

But while monetary inflation, i.e. inflation driven by growth in the money supply, is the most common cause for inflation, it isn't the only one.

There can also be "real" inflation. Real inflation can happen because the supply of goods and services suddenly gets smaller for some reason. Real inflation can also happen because we have to fork over more goods and services equivalents to get imports we need - usually petroleum products and/or food, but not always.

Real inflation makes us, collectively, poorer. In contrast, monetary inflation doesn't change the aggregate amount of goods and services we consume, although it make redistribute them if wages grow faster or slower than the cost of good and services.

Interest rates don't do anything to address real inflation, because interest rates act on the money supply, and if the money supply isn't the problem, this tool doesn't work. Instead, increasing interest rates to address real inflation produces "stagflation", where increased interest rates slow down economic growth in the real economy, while inflation rises, because inflation isn't being driven by the money supply.

Of course, I'm oversimplifying. But sometimes it is important to focus on the essentials that drive the big outcomes, rather than losing sight of the forest for the trees.