If you listen to financial pundits talking about the Federal Reserve and the current state of the markets you might hear this term mentioned:
What is it? And what does it mean for you and me?
We’ll first discuss the mainstream understanding of the concept and then unpack why it’s more nefarious than you think.
The Mainstream (Wrong) Understanding of Demand Destruction
The mainstream idea goes something like this: The Federal Reserve stimulated economic activity when the markets were frozen from Covid, but now the economy is overstimulated. It’s too hot, like an overheating car engine.
People are spending too much money, and the prices of things are going up–inflation. The economy needs to cool down, and not overheat.
The Fed stimulates by lowering interest rates. Logically, the playbook for un-stimulating, and cooling things down, is to hike interest rates. Hiking interest rates tightens up credit, reduces demand, and therefore should brings prices down.
Seems plausible enough. But let’s dive deeper.
The Economic (Real) Meaning of Demand Destruction
Let’s start with a basic question to cut through all the jargon and economic euphemisms.
Who constitutes demand for goods and services in the economy?
When the Fed speaks about needing to reduce demand to lower the prices of goods and services, they’re referring to YOU!
The word “economy” is just a term of convenience to describe the trillions of market transactions that involve individuals, you and me.
“The Economy” can’t read a blog post, earn interest on gold, or be unemployed. But all three of those things can happen to you (hopefully not #3!).
Demand Destruction = Unemployment
When the Fed says it’s going to reduce demand, that’s Fedspeak for YOU losing your job. When you’re unemployed, you consume less, and prices go down.
They get what they want: You getting fired.
Those 100,00 tech employees are much less likely to splurge on a new car, go out to dinner, or buy a new pair of sneakers.
Can we just pause for a moment to cry out from the rooftops that this is an outrage!
Hundreds of thousands of individuals just became casualties in a financial war that the Fed started itself in the first place!
Demand destruction is immoral. Full stop. Individuals should not be sacrificed at the altar of Fed monetary policy.
Watch our CEO rant about the immorality of demand destruction in our latest podcast episode. Take a listen.
Adding Insult to Injury
Despite the deep wrongness in what the Fed is doing, it may seem like they’re accomplishing their purpose. Prices are likely to go down if they keep hiking rates and destroying
But it’s actually worse than that. While they may get what they want in the short-term, the longer-term effects of this policy could backfire in a big way.
To understand this, we must pay homage to one of the giants of Economics, Jean-Baptiste Say, and Say’s Law.
What does Say’s Law Say about Demand Destruction?
Say’s Law explains that each person’s demand of the market comes from what he supplies to the market. In other words, if you produce and sell 10 loaves of bread, then you can buy the equivalent value in meat. Rate hikes cannot reduce prices because supply is demand. The Fed is trying to cut demand, by ruining suppliers.
Macy’s is a timely example.
What were they doing before this announcement?
Cutting everything, from prices to employee hours, and any expenses in between. Its bid on everything from electricity to enterprise software was softened. Its employees, faced with reduced net pay, cut back as well.
There, lower prices, see?!
Not so fast.
The economy is not a static snapshot. It is a dynamic system. Every day, economic actors make decisions based on the incentives offered to them by the market (or the central planners). Prices may soften in the short term. But then, something else happens.
In the case of Macy’s, they had enough. They threw in the towel. They closed their stores, permanently. (Note that Macy’s is by no means alone in their situation. Many other retailers in similar markets face the same pressures).
Store closures reduce the supply of goods to market. And this reduction in supply will cause, wait for it…that’s right, higher prices.
The supply cannot come back at today’s higher interest rates. Macy’s, and all other businesses, cannot borrow at a rate higher than the return they expect on the capital. The higher the rate the higher the return they need. Return on capital in retail can only rise by the closure of numerous stores.
Meanwhile, demand does not fall as much as one would think. We have a vast welfare state, in an attempt to ensure that even those who do not supply goods to the market can still demand goods from the market.
Therefore, the Fed’s attempt to lower prices will end up causing higher prices. Talk about adding insult to injury!
Making a Wrong, More Wrong
The Fed thinks to reduce demand—and demand is indeed reduced—but not via the mechanism that its theory supposes. The actual pathway is quite different. As we saw in our Macy’s illustration, a different path leads to the opposite outcome than the one predicted by the Fed.
Hiking rates to fix inflation is monetary quackery, like the Medieval practice of bloodletting to help patients heal. The more blood they took, the more patients were weakened.
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