Why Higher Interest Rates Won’t Solve the Inflation Problem

Interest rates are heading higher, and the economic toll from the rapid, ongoing rise in the cost of credit is only starting to unfold. But higher rates won’t fully fix the inflation problem.

There are two blind spots. First, aggressive rate hikes by the Federal Reserve are only half of the tightening story. How the central bank deals with its balance sheet—which roughly doubled during the pandemic to about $9 trillion, equal to about 40% of U.S. gross domestic product—is crucial to fighting inflation. Second, structural labor-market problems might undermine the effectiveness of a higher policy rate in a way that is underappreciated by central bankers and investors.