Inflation still too high. Are higher interest rates needed?

Inflation is once again rising in the United States, despite unprecedented rate hikes last year.

So, what is going on? Is the US Federal Reserve slowly losing control of inflation again? Does this mean that higher interest rates are needed?, and does that in turn spell trouble for your investments, your potential mortgage, or if you are in Europe or Japan, for the value of your currency.

The debate among economists is heated, especially after Harvard professor Larry Summers harshly criticized the Fed for having

“itchy fingers to start cutting rates”

despite there being, in his view, strong evidence that the US economy is growing so fast that it is causing inflation to spiral back out of control. So, to find out if higher interest rates are back on the menu, I’ve once again been digging through the latest economic graphs and research which, in my opinion, show that the US economy is not as strong as it may seem on the surface, and that the recent inflation uptick has largely been driven by the strange dynamics in the US housing market, which has been frozen in place as people are unwilling to get into mortgage debt when interest rates are potentially at their highest. But, to answer the question whether or not the Fed will start cutting or raising rates later this year, we need to get into the head of the Fed first and do a quick recap of

How the Fed thinks it controls inflation

After all, if we want to understand what the Fed will do next, we need to understand how it thinks.

Simply put, the Fed, like any other central bank, believes that it can control inflation in two main ways. The first is by raising or lowering interest rates today and the second is by communicating what it will do with interest rates in the future.

The main idea behind setting the interest rate today is that the overall price level in the economy is determined by overall supply and demand. If there is inflation, that is if all prices rise at the same time, it means there is either too much demand or not enough supply. The central bank can control inflation because it can control overall demand in the economy. That is, if the central bank increases interest rates, this should lower demand because it incentivizes people to borrow less, and it makes asset prices go down, which should both reduce how much people spend on goods & services.

However, because central banks believe that inflation can also be a self-fulfilling process, where people can create inflation today merely by expecting inflation will happen in the future, just setting the interest rate today is not enough. For example, if, after a big global oil crisis, inflation temporarily hits 8%, people might just expect that this is the new normal, and, in response, businesses might already start raising their prices by 8% for the next year. And, at the same time, labor unions might start demanding wages be increased by 8% as well. Therefore, even if the oil supply crunch is quickly fixed, inflation in the next year might again be 8% because business have already raised their prices, and workers have already been promised a big raise. Of course, if inflation is then again 8%, businesses might again raise prices and wages the year after that as well, and so, on.

This self-fulfilling expectations scenario is a central bankers worst nightmare, and therefore they want to avoid it at all costs. To do so, they closely monitor people’s expectations about inflation and if they feel like these expectations remain close to the 2% target, then central bankers will feel more comfortable with inflation today being temporarily above target.

This is why central bankers felt quite comfortable to keep interest rates low when inflation first started to rise after the pandemic. They thought, hey this inflation spike is now mainly caused by supply disruptions and because people believe that we are committed to keeping inflation at 2%, inflation should by itself fall back to 2% once these supply shocks are over. However, then, when these disruptions took longer than expected, even central bankers in economies where supply was still the biggest problem felt like they had to act, because having inflation too high for too long would bring them closer to the self-fulfilling expectations scenario in which much more drastic rate hikes are needed.

However, when central banks started to raise interest rates, this would not immediately have led to lower inflation. Specifically, Fed researchers have estimated that higher interest rates for banks take up to about 18 months to translate into higher interest rates for everyone, as most people that have loans, will have locked in an interest rate for a certain number of years. For example, a higher mortgage interest rate today, will only affect those people that are trying buy, or sell a house today, as well a few that will need to update their mortgage contract. And, so, the impact of higher rates on the housing market will take some time to be felt by most people .

Therefore, rate hikes in March 2022, likely only started to slow down inflation in mid 2023, and haven’t yet shown their full effect, even today. That being said, up to December, rate hikes still looked like they were working as the prices of the most sensitive categories were falling rapidly, and even less sensitive, or in economic jargon, sticky, prices also started to fall slowly.

Perhaps even more importantly, while people’s inflation expectations for the next five years temporarily shot up to 2.5%, on average, they were then again close to 2%.

And, this is why, in December, the Federal reserve was very optimistic that 5% interest rates were high enough, and that it could soon start cutting interest rates again.

Of course, as we now know, things would soon take a turn for the worst. First, just the prospect of future interest rate cuts alone was enough to drive financial markets higher than ever, which could potentially increase demand in the economy again as it makes people feel richer. But, even worse for the Fed, for the last three months alone, inflation consistently was higher than what its economists had expected, and now even started to move up again, potentially risking that inflation expectations would soon follow.

So, then, why is the Fed not yet raising interest rates? That is very strange indeed, at least, according to influential US economist Larry Summers who thinks that there is now overwhelming evidence that

Higher interest rates will be needed to kill inflation

Specifically, in a recent Bloomberg interview Larry Summers gave four pieces of evidence why interest rates will need to increase.

The first is that, despite the idea that high interest rates should reduce demand, consumption in the US economy is actually booming, growing much faster than in comparable economies like Europe, and Japan, where inflation is dropping.

The second reason that professor Summers gave is that financial markets were once again booming, even though one of the core ideas of increasing interest rates has been to slow down financial markets, which should then in turn decrease demand.

Thirdly, professor Summers pointed out that the activity of traders in financial markets shows that they now expect that future interest rates will be well above 4%, whereas the Fed still officially expects them to go back to 2.6% in the long run. In other words, he points out that, on average, all of those smart analysts in financial markets agree with him that the Fed will see the light sooner or later and keep interest rates high.

Finally, professor Summers pointed out that, as I have recently discussed on this channel, global competition between countries like China, Russia, and the US is increasing, which has kept government spending on strategic industries and defense very high, which in turn is keeping demand very strong. Therefore, the Fed will have no choice but to keep interest rates higher if it wants to offset the increased demand that this government spending binge will inevitably bring.

So yeah, some quite convincing arguments indeed, perhaps even to the Fed, given that they have now signaled that they will not start cutting interest rates as quickly as they previously wanted. However, as you may have picked up… not cutting rates as quickly … still means that they think that

Higher interest rates will NOT be needed to kill inflation

So, despite looking at increased inflation, a booming US economy, booming financial markets, and likely permanently increased government spending, what on earth could possibly have convinced the Fed to keep rates where they are?

Well, going through a lot of research from Fed economists, and other economists, I have found 4 main arguments as to why the Fed will NOT raise interest rates again soon.

The first argument is that the recent inflation uptick was largely caused by a skyrocketing price of housing, which has, strangely enough, been made worse by interest rate hikes, so far. You see, recent research by the Financial Times Alphaville blog shows that the latest inflation uptick has for a large part been caused by an uptick in the cost of housing, which is measured mostly as the sum of what renters pay in rent, and what people who own a house WOULD hypothetically rent out their home for today.

That’s right, a big part of how the US measure an increased cost of living for homeowners, is not actually real.

Now, the idea of asking home owners what they would rent out their home for is that this is a reflection of the monthly cost for their home, where the rationale is that they could have used the money that is tied up in their home for other things.

However, this is still purely hypothetical and really not something that home owners feel in day to day life. For example, I own a home, and if the price of houses goes up in my neighborhood, I don’t really feel like my life is getting more expensive because the number that I would rent out my home for, hypothetically, has just gone up.

This is why in Europe and Japan, they don’t actually include this measure in inflation calculations. In fact, if they did, inflation would be quite a bit higher in Europe. However, I actually agree with the Americans here, in that it is good to have inflation reflect higher house prices, rather than just looking at rent, because home price inflation is a really big part of inflation, for everyone who does NOT already own a home.

But, this does bring us to another problem, and that is that the Fed’s higher interest rates have so far had a very strange effect on the housing market. Instead of helping to lower house prices by making mortgages more expensive, increased interest rates have so far only frozen the housing market in place. After all, if you have legacy mortgage with a 3% interest rate right now, it is a really bad idea to move to another home, where you potentially need to refinance your mortgage at 7%. Therefore, people essentially stopped selling homes in the U.S. whenever they could, driving the price back up, even though higher mortgage rates should have driven the cost of housing down.

So, arguably, higher interest rates are temporarily causing increased inflation in the housing market, meaning that raising the interest rate even further, might not be the solution, whereas lowering it faster could convince people to start selling their homes again, driving house prices down.

So, in summary, the first argument why the Fed will not raise rates soon, is that increased home prices are for a large part responsible now, and the Fed might counterintuitively be able to fix this only by lowering interest rates to unfreeze the housing market.

The second argument why the Fed will not need to raise rates is luckily a bit simpler and that is that the other important prices, like producer prices and wages, that the Fed typically looks at, are signaling that inflation is still cooling down fast.

Thirdly, while America’s economic growth numbers may look great on the surface, this might soon change as, fewer people are able to repay their debts, and job seekers report en masse that finding a job is again way more difficult, despite what the numbers may suggest.

And, finally, is it important to note that the Fed is not just looking at inflation, it also wants to prevent a financial crash, and given that there are still a lot of worries about the health of the US banking system after the Silicon Valley Bank collapse last year and worries about the sustainability of US government debt with interest rates around 5%, it could very well be that the Fed deems these threats too great to raise interest rates any time soon.

So, what does that mean for our main question

Are higher interest rates coming?

Well, you’ve heard and seen the 4 arguments from both sides.

Of course nobody can predict the future. But, so far, I think that if we take into account that the housing market has reacted unexpectedly to the Fed interest rate hikes, that the US economy has some pretty weak spots and that for the rest inflation is still on its way down just as it is in Europe, I suspect that in hindsight this inflation bump will have been just that: a temporary inflation bump, which caused the Fed to delay lowering interest rates for a bit.

That being said, I partially agree with professor Summers that factors like deglobalization, and heavy fiscal spending on stuff like industrial policy mean that interest rates will likely not return so close to zero as they were before the pandemic.

But yeah, that is my take. Please, always consider multiple sources before making up your mind about stuff like this, especially when it comes to subjects that are increasingly politicized like inflation.

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