Inflation

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How interest rates decrease inflation ?

Inflation happens due to a number of reasons, but inflation is just an increase in price. If demand is higher than supply in the market, be it for a granola bar or for a great bottle of bourbon, then price increases. It’s this imbalance between demand and supply (demand surplus over supply) - that drives inflation

So, the Federal Reserve increases short term interest rates called - Effective Federal Funds Rate (here). When you increase interest rates (the cost of borrowing), the intuition here is people would borrow less, and spend less, and demand less things, and hence supply can catch up to demand, and as that gap between demand and supply decreases, inflation decreases, and price decreases

Does increasing interest rates decrease inflation in the real world ?

It’s classic monetary policy and it has worked since the dawn of time for the United States. From the 1973 oil embargo and 1979 Iranian Revolution (when shortages in energy supply led to rampant inflation), to the last two years after we came out of the pandemic - we have used interest rates to decrease inflation. From inflation being at a record high of 9% in July 2022, an increase in interest rates has effectively decreased inflation to ~ 3% currently. So - yes, it works

Is there an official target for inflation and what is it based on ?

The Federal Reserve target for inflation is 2%. It means, that if the price of Nike sneakers was $ 100 last May, and if it is $ 102 this May (2% increase), then it is said to be acceptable. But if it is $ 105 this May, then inflation is 5% and it is not acceptable

This isn’t physics with an actual provable estimate for speed of light or gravitational constant. The 2% target is decided at the Federal level as an acceptable level of inflation, year over year. Since, it has worked for a long time, the Federal Reserve makes monetary policy decisions based on where inflation is, relative to that 2%. The proof is in the pudding - increasing rates to curb inflation has balanced historically strong economic growth with low unemployment in the US

It also provides a sense of predictability on when the Federal Reserve would react to managing inflation, based on whether inflation is too high or too low. If inflation is running hot (higher than 2%, similar to now), then the Federal Reserve will increase interest rates to depress demand, and thus decrease inflation - and vice versa

What is the problem in keeping interest rates high (to manage inflation) ?

There is a cost to keeping interest rates high. A high interest rate implies high cost of borrowing - for both people and businesses. With high interest rates, people are less likely to borrow and spend, and businesses are less likely to borrow, spend and expand - and this eventually reduces economic (GDP) growth. High interest rates also keep mortgage rates high, because mortgage rates are driven in part, by the interest rates set by the Federal Reserve

What about unemployment ?

When people eat out less, to save money (because the cost of borrowing money is high), then restaurants hire less (increasing unemployment). When a business decides to borrow less and expand less aggressively, then they hire less people, and even let go of some of the people they have on payroll - once again, increasing unemployment

Interest rates make it expensive to hire new people (if you need to borrow money to run your business), so it increases unemployment

Is the Federal Reserve independent from the White House, when making decisions about interest rates, to effectively manage inflation ?

This is complicated. The Federal Reserve’s primary responsibility is to keep the economy healthy, and that requires balancing inflation, interest rates and unemployment. There have been presidents in the past who have tried to influence the Federal Reserve for political purposes (you can read more here). For the most part, the current Federal Reserve chair Jerome Powell makes decisions based on foundations of macroeconomics rather than politics (until now)

Are there more layers to this ?

Of course - it’s real world economics

The United States is a 25 trillion dollar economy, and things happen. High interest rates are supposed to depress economic growth. But, even with very high interest rates, we have continued our healthy economic growth (surprisingly), because of three reasons

Supply chain problems went away and that gap between demand and supply decreased, so the economy grew even under a high interest rate environment. But wait ? doesn’t inflation decrease when that gap between demand and supply decreases (like we talked about above ?), so shouldn’t the inflation problem be solved by now ? Yes, but, not if demand increases too, and maintained that gap. When people came off the pandemic they had lots of savings and demand went up too. So that gap did not come down as much as it should have, so inflation came down, but slower than we expected it to

We talked about Rockets and Feathers last week, about how businesses increase prices faster like a rocket and decrease prices slower like a feather. Even when supply chain problems went away and supply picked up, businesses still kept prices relatively high - which led to inflation problems. It’s just capitalism (don’t tell anyone I said that). It’s called greed-flation, and here is Kansas City Fed’s work on that

Due to immigration, more people joined the workforce, and since more people joined labor supply, it became cheaper for businesses to hire people (even under a high interest rate environment). So, the economy grew at a healthy pace, when it shouldn’t have

A combination of all these intertwined reasons - contributed to strong economic growth, even under a high interest rate environment

So it’s a high wire balancing act between interest rates, unemployment and inflation

What if we cut interest rates too soon ?

If we cut interest rates before inflation reaches its intended target of 2%, we risk making it worse. A decrease in rates is likely to cause a spike in economic activity, which can lead to inflation increasing again, in which case, we would have to increase interest rates again. That’s a nightmare

What if we cut interest rates too late ?

If we cut interest rates too late (such as keeping interest rates high for long, hoping inflation will reach 2% at some point of time in the near future) - then we risk depressing economic growth, so much that we dip into a mild recession. If the current labor supply decreases drastically, then this can happen too

So, what then ?

Read unemployment, inflation and economic growth data every month as they come out, and make the best decision possible, and do it in increments, as opposed to whole sale changes in interest rates

Getting inflation down to 2% without invoking a recession is what we call - The Soft Landing, or the Goldilocks Scenario

And the stock market ?

Investors for the most part, chase yield. So, as short term interest rates increase, the yield from treasury notes increases. So, investors who are risk averse will buy more treasury notes and bonds, as opposed to stocks (which contain more risk). This really comes down to how investors think about their own risks and rewards, and the tradeoff between those two

As the difference in yield between treasuries and stocks decreases, investors have less incentive to take on more risks by buying volatile stocks - that’s the intuition of how to think about investing in treasuries and stocks in a high interest rate environment

There is sheer poetry in economics, isn’t it ?