Campaign to Raise Interest Rates is Misguided
By Victor Sperandeo with the Curmudgeon
We examine a fallacy which the Fed uses to mislead the public by raising interest rates to “fight inflation.” Its agenda is largely based on the Phillips Curve - an academic theory that inflation and unemployment have a stable and inverse relationship. The Fed believes that raising rates will slow economic growth causing higher unemployment which will result in lower inflation.
In a previous Curmudgeon post, we stated that the Phillips Curve was disproven during the 1970-1981 period of stagflation, when there were high levels of both inflation and unemployment. The U.S. unemployment rate went straight up with the huge inflation of the 1970’s to early 1980’s (from 3.90% in January 1970 to 10.80% in December 1982.
As we’ve explained many times, the Fed also believes in a “reverse wealth effect” such that rising rates will cause asset prices to decline, making people feel poorer so they spend less which would theoretically lower inflation.
Effects of Fed Rate Increases:
Raising interest rates is like hitting the brakes on economic growth: It slows consumer and business demand in order to bring down inflation. However, rate hikes don’t have much of an impact on large corporations, because they don’t borrow much (except to buy back their shares) and can raise prices to offset higher inflation.
-->It’s the small businesses, the middle class and the poor that suffer when rates rise, and layoffs accelerate.
The overall economic slowdown caused by higher rates negatively impacts small businesses. They are often forced to enact hiring freezes, attrition without replacement and layoffs. In some cases, they’ve been forced to close, especially in Santa Clara, CA where the Curmudgeon has lived for 53+ years.
With higher interest rates on mortgages, car loans and credit cards, people will have less discretionary money to spend and even less if they’re laid off. Does the Fed care about that? Evidently not!
Future Fed Rate Hikes?
“It wouldn’t have been thinkable to have a 5% (Fed Funds) interest rate before the pandemic,” Jerome H. Powell, the Fed’s chair, said on Thursday. “And now the question is: Is that tight enough policy?”
FOMC members expect to raise their Fed Funds policy rate two more times in 2023, to 5.5% to 5.75% from just above 5% now. If those moves happen at an every-other-FOMC meeting pace, that will mean rate increases at the central bank’s meetings in July and November 2023.
Currently, the CME Fed Watch Tool indicates an 84.3% probability of a 25bps rate hike (to 5.25 to 5.5%) at the July FOMC meeting. There’s a 46.4% probability that Fed Funds will be 5.5% to 5.75% after the November FOMC meeting. That’s the highest of any Fed Funds rate forecast for that meeting.
The Fed’s 2% Inflation Target:
The Fed’s arbitrary goal of 2% inflation, using the Personal Consumption Expenditure (PCE) Price Index [1.], is said to be most consistent with the Federal Reserve’s mandate for maximum employment and price stability.
Note 1. The PCE price index, released each month in the BEA’s Personal Income and Outlays report, reflects changes in the prices of goods and services purchased by consumers in the U.S. While the Consumer Price Index (CPI) assumes a fixed basket of goods and uses expenditure weights that do not change over time for several years, the PCE Price Index uses a chain index and resorts on expenditure data from the current period and the preceding period (known as Fisher Price Index).
Recently, there have been huge declines in the PCE and CPI rate of change from the previous month and year:
l The PCE increased 0.1% in May 2023 and 3.8% year over year (YoY). That was the lowest reading since April of 2021, while April 2023 advance was revised down to 4.3%. This chart shows the declining trend in the PCE since it peaked in June 2022:
For more details, please refer to Table 9 in this latest BEA report.
l In the last 15 months, the rate of change in the CPI declined by -56.1% (+9.1% to +4.0%). The Fed has consistently said that is not enough and that “we must do more (rate hikes).” Based on what standard?
The last period of high inflation was the 1970’s and early 1980’s. Here are the annual official CPI increases (PCE was not available during those years) with the % change from the previous year:
l 1979 +13.29% (vs 7.59% in 1978 or -42.9%)
l 1980 +12.52% (-5.8%)
l 1981 +8.92% (-28.8%)
l 1982 +3.83% (-57.1%)
l 1983 +3.79% (-1.0%)
I’ll leave it to the reader to judge if the 15 month decline in the CPI rate of change is large enough for the Fed to stop raising rates?
Evidently not! When Jerome Powell was asked this week when inflation will return to the 2% target, the Fed Chairman straight up said it won’t happen before 2025—a very long time for a policy maker to concede failure. That now makes it crystal-clear short-term interest rates are going to stay higher for longer.
Cartoon of the Week:
Please keep in mind that the CPI is not inflation, but a highly subjective manipulation of prices the U.S. government puts out.
Inflation is classically defined as: “an increase in the volume of money and credit RELATIVE to the available goods (and services) -RESULTING - in a substantial and continuing rise in the general price level.” Merriam Webster dictionary, 1965 edition.
Today, inflation is defined as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”
As John Maynard Keynes so aptly put it (emphasis added):
“There is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which NOT ONE MAN IN A MILLION is able to DIAGNOSE.”
1. The Fed employs just over 400 Ph.D. economists, who “represent an exceptionally diverse range of interests and specific areas of expertise. They produce a wide variety of economic analyses and forecasts for the Board of Governors and the Federal Open Market Committee.”
If they’re so smart and knowledgeable, why don’t they realize the harm they’re doing to the economy by excessive rate increases?
2. The U.S. economy works well for everyone when there is stable money supply growth (of 5-6%), balanced budgets with low government spending (mostly for essentials), and low taxes (which enables people to keep more of their money to save and invest).
That was the case during the Calvin Coolidge administration (1923 to 1929) and the Reagan administration (1981-1988).
Calvin Coolidge has by far the best economic record in U.S. history. The “Roaring Twenties” had negligible inflation (+0.25% compounded in 7 years), budget surpluses every year, stable government spending and low interest rates. There were also tax cuts from 58% to 24% during 1923-29.
Coolidge’s philosophy was:
“Unless the people, through unified action, arise and take charge of their government, they will find that their government has taken charge of them. Independence and liberty will be gone, and the general public will find itself in a condition of servitude to an aggregation of organized and selfish interest.”
Success, good luck and till next time………………..
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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