What Higher Interest Rates Can’t Do
by David Reavill
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, just what is inflation? and 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 basic 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 there are more people who want to buy than candy for sale. So the shopkeeper keeps raising their price (inflation), ideally until the amount of candy, at the new higher price, equals the amount of buyers willing to pay that price.
This is an equation that 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. Like the candy store, some of the customers decided to drop out and not buy. Demand was diminished, especially among those buyers who bought on credit. They were no longer willing to pay the higher interest rate to make their purchase.
This is called demand destruction. And because America back in the 70s and 80s was an economy that could easily become balanced, the Fed’s higher interest rates did the trick. They dampened demand enough so that supply/production could ramp up to be in balance. The result was that America embarked on one of its greatest growth periods. Through the remaining ’80s and 90s, the economy was strong, productive, and balanced. Prices are held in check for the next generation.
Unfortunately, America today does not resemble the America of a generation ago in three critical respects.
First, there has been a dramatic change in the population in the country. The baby boom generation is retiring. Becoming less productive than 20 or 30 years ago. The supply side of the demand-supply equation is diminished.
Second, America has shipped much of its manufacturing overseas. We call this the “Supply Chain,” and it 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 largest injection of money in history. As I’ve pointed out before, basic money (the M1 Money Supply) 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 pumps 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 are most likely to raise rates again in November and again by 3/4ers%.
Let’s project how these higher rates will impact our three basic 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 very little effect on an aging population.
How about off-shore manufacturing? Again, interest rates are the wrong tool in bringing about a return of production to American shores. 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.
As to that “stimulus” program of unrestrained money printing, I’m afraid its a case of what’s done is done. We can’t take it back. And so were faced with working through the full impact of a new, post-stimulus dollar. We really have a new currency, that is going to be worth less than the currency we had before 2021.
So, raising interest rates will not impact the country’s demographics. Nor will it bring home our off-shore manufacturing. Not 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 slower shipping, while Ford and General Electric warned of higher costs. This is a trend I expect to see grow as we get closer to the most important sales period of the year: those Fourth Quarter Holiday Sales.
I have it from a reliable source that Santa is feeling a little peaked right now.