Louis Johnston, professor of economics at the College of St. Benedict and Saint John’s University, explains how financial tightening lowers inflation.
“We live with what are called negative real interest rates, which means that banks, in a sense, are paying borrowers to borrow money. And now interest rates have finally risen enough that we have positive real interest rates. It is the amount of money that people borrow and have to pay back in more valuable dollars.
The federal funds rate, now four percent, determines how much banks can earn by keeping their reserves held in the various branches of the central bank. In order to lend these reserves, the project must generate a high return with a low risk of failure. Many borrowers are excluded, forcing them to rely on available cash and limiting speculation.
Federal Reserve Chairman Jerome Powell is trying to figure out how long it will be before rate hikes have an effect. Johnston says there are several factors when trying to determine the delay.
“Milton Friedman said that monetary policy works with a long and variable lag. It depends on the state of the economy. It also depends on the financing needs of businesses. So, for example, if you are in a situation where companies don’t need to borrow a lot, they fund their investment from retained earnings, it’s going to take some time.
Companies borrowed heavily when rates were at record highs in 2020 and 2021. Companies posted record corporate profits ahead of the Fed’s policy change. Many are well positioned to avoid further short-term debt. Johnston thinks the lag this time will be between six and nine months. Inflation could remain high until then.