Perhaps the major topics we covered during our recent “Fred After Dark” broadcast was inflation and the effect of interest rates on it or, if preferred, vice versa.
Yes, among the various periodicals and newspapers I read, I do read the NY Times (horrors!). However, they do have a couple of excellent financial writers on staff and one, Jeff Sommer, wrote an excellent piece that should serve as a good follow up both to the broadcast as well as the program notes. An excerpt from Saturday’s column on the subject is below which quotes the bond maven from Schwab as well as Nobel Laureate in economic science, Edmund Phelps (Columbia U).
“So how might raising interest rates help here? One way of looking at rapidly rising prices — a.k.a., a high rate of inflation — is as an imbalance of supply and demand. By raising short-term interest rates, and by influencing rates elsewhere in the economy, the Fed is making it more expensive to borrow money.
Mortgage rates are rising, for example, making it more costly to buy a house. That may not lower inflation in home prices immediately because the supply of materials and available workers is so tight and demand is so high, mainly because of the pandemic. The Fed can’t do much about those shortages. But as they resolve, perhaps within a year or so, higher interest rates are likely to shift the relationship of supply and demand, lowering the rate of inflation…
By raising rates, the Fed is trying to make you slow down your spending. That happens when the cost of money goes up for a car loan or mortgage or something else you want to spend money on. At some point, you’re going to pull back. The higher cost of money reduces your purchasing power — what you can afford to buy — and the Fed is effectively making you buy less. And that should bring down inflation…
You can look at our situation as aggregate demand exceeding supply, and that’s causing prices to rise,” so the Fed needs to “clamp down on demand” by raising interest rates.
Sadly, though, if interest rates go high enough for long enough, economic growth will slow and some people will lose their jobs. “When the unemployment rate turns out, after careful analysis, to be very low, and when inflation is high, then we do want to put a lid on it and the Fed does need to raise rates. But that will have consequences.”
An economic slowdown associated with a decline in the rate of inflation could deteriorate into an outright recession. But the Fed is trying to avoid that and engineer a “soft landing” — a state of Goldilocks perfection, in which growth is neither too fast nor too slow, and prices are just right.
Financial markets are reacting not just to what the Fed does but also to what it says it is going to do. The Fed’s pronouncements about where it expects interest rates and inflation to go are called “forward guidance.”
This kind of communication was less common 30 years ago. But a series of Fed chairs — Alan Greenspan, Ben S. Bernanke and Janet L. Yellen — expanded the practice. Jerome H. Powell, confirmed for his second term as the leader of the Fed on Thursday, has made it central. The Fed uses official statements, publicly disseminated economic projections, speeches, interviews and news conferences to tell the markets where it wants them to be heading.
At this moment the Fed may be “scaring people in financial markets into believing that they should lower their expectations of inflation.”
The Fed is saying we should believe the inflation rate is going to fall as a result of the Fed’s efforts.” The idea is that “the markets are already expecting that the Fed is going to succeed in lowering expectations of inflation, and that will lower inflation itself.”
That’s the theory, at least. There’s some evidence that it works. Longer-term interest rates have risen substantially this year, not just as a mechanical response to increases in the Fed funds rate but as a reflection of changing views in the markets of where the Fed wants interest rates and inflation to be a year or two from now.
This approach has a drawback, however. It’s like the old game of telephone. Start by whispering “higher interest rates and a soft landing in the economy” and, before you know it, this message, transmitted from person to person, has become totally different. The Fed’s messages mean different things to different people. Some people are hearing “recession.”
That is a major reason for the heightened anxiety and volatility in the markets. There is no stable consensus on where the Fed is going or whether it can get there…
The Fed’s efforts to combat inflation are a grand experiment. Like it or not, we’re all part of it.”