Are interest rate hikes the solution to rising prices?

Much has been made of the fact that the western world is experiencing rates of inflation last seen 40 years ago. That’s certainly true of the US, the world’s largest, and most important, economy. There are similarities between the inflation we’re seeing today and that of the 1970s. In both cases oil prices are a major contributor to price pressures. But 1970s inflation was higher than today. It also accelerated over the decade, from around 2% in the 1960s to over 14% by 1980. While energy costs are a factor today, forty years ago a barrel of oil quadrupled in price during the 1973 oil embargo and doubled again in 1979 following the Iranian Revolution. Oil may be over $100 per barrel today, but its rise isn’t a shock like it was back then. We’ve also coped with high oil prices a number of times since the beginning of this century.

Selective

In the 70s, inflation was everywhere. Today it’s more selective. Some parts of the economy are experiencing rapid price increases (used cars for instance) while others have steady or even falling prices. Much of this has to do with the supply-chain issues, often as a result of pandemic lockdowns, something that central banks can’t control. Prices of goods and services should settle down as we get back to normality. Wages are rising, but this is due to skill shortages rather than unionised workers demanding inflation-busting pay rises. Also, while the US Federal Reserve was caught out by thinking inflation was ‘transitory’, they are finally adjusting rates up. Hopefully, they will do this in a measured fashion to ensure a soft landing. Back then, it took a decade and the appointment of Paul Volker as Fed Chairman before interest rates were pushed high enough to help drive down inflation. There was also a different mindset. The idea of a ‘zero’ let alone a ‘negative interest rate policy’ was unthinkable. As was the prospect of central banks expanding their balance sheets and intervening in the markets by buying up bonds and other financial assets. Back then we had interest rates that were higher than the rate of inflation. That’s something that is unthinkable now. With US CPI inflation around 8.5% year-on-year, and interest rates now at 1.0%, we need the Fed Funds up above inflation just for savers to maintain their purchasing power. Instead, the US currently has a negative interest rate of 7.5% (8.50 minus 1.00).

Messed up

There’s a growing feeling that the Fed has messed up – again. It has spent years trying to push inflation to its 2% target rate, as measured by Core PCE. Ever since the Great Financial Crisis of 2008/9 they’ve kept monetary stimulus loose. But while the standard measures such as CPI failed to pick up inflationary pressures, hard evidence of rising prices was everywhere. Soaring equity markets, bonds, real estate, artworks, jewellery, classic cars all testified to the fact that money was just too cheap. When they tried to tighten, and it took the Fed from December 2015 to December 2018 to raise rates from 0.25% to 2.50%, stock markets slumped, causing the Fed to reverse course. There was additional monetary stimulus in response to the pandemic. Not only that, but we saw an extraordinarily large dollop of fiscal stimulus too. This turbocharged the US economy coming out of lockdown and finally created inflation. At the beginning, central bankers insisted it was transitory and so had an excuse not to raise rates. Now they have been proved wrong and are being forced to take action. But will it work? Will rate hikes calm the inflation that central bankers and policymakers created in the first place? Is this the right response, or just a public relations exercise in being seen to do something? Is it a desperate attempt to put a lid on inflationary pressures which are already putting a huge strain on households? Inflation is terrible for savers and those on a fixed income. But it also destroys debt, and there’s more debt in the world than there has been in the whole of history. That’s why central bankers could prove to be a lot less hawkish than many analysts currently think. Growth is already slowing. The Fed could have acted sooner, but it missed its opportunity to raise rates modestly and engineer a soft landing. But should they be too aggressive over the next three months or so, they risk crashing the market and causing a recession. That’s why for all the fury and bluster about inflation, central banks may prove to be less proactive than expected when it comes to taking action.