What Higher Interest Rates Can’t Do

The Federal Reserve Open Market Committee

At 2 o’clock this afternoon, eastern time, the Federal Reserve will announce its latest move in interest rates. Their objective is to curb this runaway inflation that we’re experiencing. So, what is inflation? How will raising interest rates help stop inflation?

The basic definition of inflation is too many dollars chasing too few goods and services; this is the definition that most economists are comfortable with and the one that the Fed is following today. It’s a definition that looks at primary supply and demand in the economy, concluding that the demand side is stronger than the supply side of the equation.

Think of a candy shop. Inflation is when people line up to buy candy, but more people want to buy than the shop’s supply. So the shopkeeper keeps raising their price (inflation), ideally until the amount of candy, at the new higher price, equals the number of buyers willing to pay that price.

Adjusting the demand, the number of “candy buyers” worked like a charm in old America. The old America was self-sufficient, able to produce as many goods as it could consume. So, in the late 1970s, the last time we experienced inflation as we have now, the Federal Reserve also raised interest rates to dampen demand. These higher interest rates diminished demand, especially among those buyers who bought on credit. They were no longer willing to pay the higher interest rate to make their purchase. Some customers decided to drop out, not buy.

These higher interest rates produce a higher borrowing cost and diminish demand. Because America in the 70s and 80s had a plentiful supply or industrial production, the economy could become balanced by adjusting one factor: demand. The Fed’s higher interest rates did the trick and stopped inflation in its cold.

The Fed dampened demand enough so that supply/production could ramp up to come in balance. The result was that America embarked on one of its most significant growth periods ever. Through the remaining ’80s and 90s, the economy was solid and productive, and balanced. The Fed had held prices in check for the next generation.

Unfortunately, America today does not resemble the America of a generation ago in three critical respects.

Interest Rate, Fed Funds (red) GDP Now, Current Economy (blue)

First, there has been a dramatic change in the population in the country. The baby boom generation is retiring and becoming less productive than 20 or 30 years ago. The supply side of the demand-supply equation is not as capable as it once was.

Second, America has shipped much of its manufacturing overseas. We call this the “Supply Chain,” which means that, again, we are less able to produce all the components and goods that the economy needs to regain its balance. Again, the supply side is less robust.

And finally, and I think most pertinent to today’s situation, we’ve just been through the most significant injection of money in history. As I’ve pointed out, actual cash (M1 money) was increased five-fold. From $4 Trillion less than two years ago to $20 Trillion today. All due to the “Stimulus Program.” In reaction to the Covid Pandemic, this Administration pumped trillions of dollars into our financial system. Remember, inflation is too many dollars chasing too few goods and services. Well, here’s where those “too many” dollars came from.

So, given that background, where are we likely headed?

First, I accept the Street’s estimate that the Fed will raise rates at least 3/4ers% today. Further, they will most likely raise rates again in November by 3/4ers%.

Let’s project how these higher rates will impact our three fundamental contributing inflation factors.

First, higher interest rates will have little to no impact on demographics. Oh sure, grandma may not go to the store as often as before. And in fact, she may put a little more away in her savings account now that rates are higher. And saving is a good thing. But on balance, higher interest rates will have minimal effect on an aging population.

How about off-shore manufacturing? Incentives are needed to bring these Multinational companies back home, and the Trump Tariffs and return of capital investments were a step in this direction. But as for interest rates, again little to no impact. Furthermore, interest rates are the wrong tool in bringing a return of production to American shores.

As to that “stimulus” program of direct money printing, I’m afraid it’s a done deal. We can’t take it back. And so we are faced with working through the full impact of a new, post-stimulus dollar. In essence, we have a new dollar, a post-stimulus dollar. And because there are so many more of these new dollars, they will be worth less than the old dollar we had before 2021.

So, raising interest rates will not impact the country’s demographics. Nor will it bring home our off-shore manufacturing. Nor can it take back the impact of trillion more stimulus dollars.

However, there is one thing that higher interest rates will do: the higher rates will diminish demand. We can expect the economy to slow as consumers become reticent to spend.

Already several major corporations have warned about slow business conditions directly ahead. Last week Federal Express warned of sharply lower shipping, while Ford and General Electric warned of higher costs. I expect this slowdown in the economy to continue throughout this year. Unfortunately, it will probably continue as we get closer to the most critical sales period of the year: those Fourth Quarter Holiday Sales.

I have it from a reliable source: Santa feels a little queasy.

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David Reavill

David Reavill writer + finance +iconoclast + hiker + Pennsylvania #valueside daily podcast + medium + meditate valueside.com/links