We’re likely to hear a lot about inflation when the grand poobahs of central banking meet next week in Jackson Hole, Wyoming, for the annual economic conference hosted by the Federal Reserve Bank of Kansas City.

As a primer for that, let’s review where we stand on the various channels through which monetary policy is thought to act on inflation.

The basic theory that dominates central banks in most parts of the world is that raising interest rates will decrease inflation. This is not quite universally accepted. There are heterodox economists who believe the basic theory gets it backward. They point out that higher interest rates mean the private sector receives more interest income from the government, which they say adds to inflation. Turkey appears to have adopted something like this as its official policy—to disastrous effects. So it’s probably best to assume the basic theory is correct.

There are seven main channels through which interest rate policy is thought to operate: the housing market, exchange rates, asset prices, household balance sheets, corporate balance sheets, fiscal support, and banking. There is a lot of interaction between the channels, but it is useful to distinguish between them for the purpose of analysis.

Before we even get to the seven channels, however, it’s important to note how the Fed’s monetary policy translates into higher rates. The Fed targets the overnight rate banks pay to borrow reserves from other banks. It also pays interest on reserves held by banks. This short-term rate is thought to set the pace for longer-term rates. More specifically, it is the expectation of where short-term rates will be over any given time horizon that determines longer-term rates. The yield on the 10-year Treasury, for example, can be decomposed into a series of expectations for where the short-term rates will be. Fed economists almost all believe longer-term bond yields also include something called a “term premium”—basically an extra return required by investors for holding longer-term bonds.

So now on to the channels.

Housing Market: The 30-year fixed rate mortgage tends to be priced off the 10-year Treasury. They are basically relatively safe assets that are competitors for investor dollars. So when the Fed is tightening, this tends to raise the rates on mortgages. Higher mortgage costs lower the affordability of homes, depressing demand. This slows homebuilding, which lowers demand for materials and labor.

The housing market has definitely slowed. Home builder confidence has fallen for eight months. Housing starts have fallen to their lowest level since the initial lockdown months of the pandemic. The volume of existing home sales has fallen for six consecutive months. There are signs that home prices are falling. So far, however, employment in the sector has continued to grow. And mortgage rates have begun to sink. After ticking above six percent in July, the average rate on 30-year fixed mortgages has fallen down to 5.22.

Exchange Rates: When the Fed hikes interest rates, it makes U.S. financial assets more attractive to foreign bidders searching for higher yields. This pushes up capital flows into the U.S. and strengthens the dollar relative to foreign currencies.  The stronger dollar makes U.S. produced goods more expensive to foreign buyers, discouraging exports. This causes employment in export oriented industries in the U.S. to fall, reducing income and therefore demand. It also leaves more goods to be purchased by domestic consumers, raising the supply side. The stronger dollar also makes imports less expensive, putting downward pressure on prices in U.S. markets. It can make importing energy cheaper as well.

The U.S. dollar surged higher in the first six months or so of the year, pushing the value of the euro to “break the buck.” But it has gone sideways since mid-July as central banks around the world signaled their own tightening. Like mortgages, the exchange rate channel has stopped tightening and may even be loosening now.

Asset Prices:  Higher interest rates tend to weigh on financial asset prices. Stocks fall because the discount rises for future cash flows. Bond prices drop because higher interest rates are available in new issues. Even real estate prices drop, as we saw in the housing market channel. The cost of capital for corporations increases, which can decrease investment and hiring. Household net worth declines, which produces a negative “wealth effect” that shrinks spending.

Here we see something very similar to the exchange rates and the mortgage rates story. Asset prices fell, bringing stocks into bear market territory, this spring and early summer. But stocks have been on what is nearly a five-week rally. Yields on longer-term bonds have fallen, implying higher prices. And home prices have slowed but not declined. Here too it seems like tightening has stalled.

Household Balance Sheets: The decline in the value of assets that can be used as long collateral or sold to produce income for consumption, weakens household balance sheets. Floating rate debt including credit cards and student loans becomes more expensive to service. This tends to operate with a considerable lag, but it can reduce spending, especially on things like home improvement projects.

The impressive earnings of Home Depot and Lowes in the most recent quarter indicate that tightening has not yet been felt here.

Corporate Balance SheetsSimilar to households, rising interest rates damage corporate balance sheets by decreasing the value of collateral and raising the cost of debt service. This can mean reduced investment and reduced hiring.

The blow-out July jobs numbers suggest that this is not yet weighing on financial conditions.

Fiscal Support: Raising the cost of government borrowing can act as a break on deficit spending. All other things being equal, lower deficits tend to lower inflationary pressures. This is especially true if the lower deficits are achieved through spending cuts or tax hikes aimed at reducing private sector spending. Both tend to be highly unpopular politically because spending programs tend to have enthusiastic supporters, and anti-inflationary tax hikes typically must take spending power away from middle-class voters.

Spending has come down from the pandemic rescue levels but remains extremely high. This might be having some tightening effect, but it is hard to directly measure.

Banking:  Higher interest rates discourage bank lending, which then weighs on spending and hiring by businesses and households. But with rates starting at a very low level and banks holding plentiful reserves, it’s unlikely that this channel will have much influence on inflation for quite some time.

The bottom line is that while there was some tightening of financial conditions in the spring and early summer months, since then there has been very little progress. This likely means the Fed will have to tighten faster or extend its tightening campaign for longer. Financial markets right now are priced for neither outcome. Indeed, bond and derivatives markets suggest the Fed will start cutting next year.