Interest Rates, Inflation, Wishful Thinking, and Unintended Consequences

 

The Federal Reserve's statutory mandate, as described in the 1977 amendment to the Federal Reserve Act, is to promote maximum employment and stable prices. These goals are commonly referred to as the dual mandate.

However, this dual mandate of maximum employment and stable prices can often be in conflict. A strong job market leads to higher wages, which can eventually feed into consumer prices, according to the Phillips Curve. In essence, the same economic growth that creates jobs can also spark inflation. Low inflation generally results in higher unemployment and vice versa.

When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.

Right now, we do not have stable prices. Yet, continued Fed rate hikes (aka, tightening) in an effort to control prices could ultimately lead to lower employment and even layoffs. This is the very tricky path the Fed is navigating. A lot is riding on it.

The Fed has a longstanding goal of maintaining a 2 percent rate of inflation. In the early part of the 21st Century, inflation consistently ran a little hotter than that objective. Then came the Great Recession, which followed the financial crisis in the fall of 2008. That ushered in an extended period of very low inflation, generally falling below the Fed's 2 percent goal. 

2000 - 3.4%

2001 - 2.8%

2002 - 1.6%

2003 - 2.3%

2004 - 2.7%

2005 - 3.4%

2006 - 3.2%

2007 - 2.8%

2008 - 3.8%

2009 - -0.4% (Great Recession)

2010 - 1.6%

2011 - 3.2%

2012 - 2.1%

2013 - 1.5%

2014 - 1.6%

2015 - 0.1%

2016 - 1.3%

2017 - 2.1%

2018 - 2.4%

2019 - 1.8%

2020 - 1.2%

2021 - 4.7%

2022 - 8.0%

2023 - 4.1%

*Data Source: U.S. Bureau of Labor Statistics

From 2009 to 2020, a span of 12 years, the inflation rate failed to reach the Fed’s 2 percent goal. Americans got used to historically low inflation. Then came the global pandemic, disrupted supply chains, and rampant corporate greed. Prices had been relatively stable for over a decade, so corporations took advantage of a global crisis to jack up prices, quite radically. Corporate profits as a share of national income have skyrocketed by 29% since the start of the pandemic, according to the St. Louis Fed.

The longer term trend is even more pronounced. In 2000, corporations in the U.S. made profits of $786 billion. By 2022, corporate profits reached about $3.5 trillion. That’s an increase of more than 400 percent.

It’s also worth noting that inflation is not a US phenomena; it's running high in all the OECD countries. Among G20 countries, the US inflation rate was the eighth lowest last year.

Some less informed Americans think the US President can control inflation. Wrong. The Federal Reserves tries to control inflation, but it often fails to meet its own stated objective. The Fed attempts to control inflation by manipulating Interest rates. In theory at least, when interest rates are lowered it stimulates borrowing and, thereby, economic activity. So, prices generally rise. Conversely, when interest rates are increased it deters borrowing, slowing economic activity. Yet, even as the Fed has continually raised rates, economic growth and inflation have continued unabated.

From 2022 to 2023, the Fed increased the funds rate 11 times, bringing it from a historic low of 0.08% to the current 5.33%, the highest the rate has been in over 20 years. Despite these repeated rate hikes, inflation still rose 8 percent in 2022 and another 4.1 percent in 2023. The US economy is a broad-based juggernaut and attempting to subdue it has proven to be like trying to tame a wild bull.

The funds rate is the interest rate at which all others are set, even those of the federal government, which must issue bonds, bills and notes to finance its operations. Rising interest rates are a nightmare for the U.S. government. The federal government will spend $892 billion in the current fiscal year on interest payments — more than it has earmarked for defense. Next year, interest payments will top $1 trillion, according to the Congressional Budget Office, Congress’s fiscal watchdog.

While still historically low, the current funds rate is an unsustainable figure for our deeply indebted federal government. This is why I believe there will be heavy pressure on the Fed to lower interest rates before borrowing costs become too cumbersome for Washington. Inflation will cripple average Americans, but it will inflate away some of the national debt, making interest payments more manageable. No matter how much pain inflation causes Americans, there will be heavy pressure on the Fed to cut the funds rate.

This is the course that the Fed will navigate. Cutting rates to make debt payments more manageable will likely lead to continually elevated inflation, which over the long run will likely lead to lower employment, perhaps even layoffs. Ultimately, it could lead us right into a recession. They always come, it’s just difficult to predicate exactly when.

Since the end of World War II, the U.S has suffered through 12 recessions, or an average of one every 6.5 years. The last economic expansion, starting at the end of the Great Recession, lasted 128 months. By that measure, we were overdue for an economic retraction when the Pandemic Recession hit. 

For those most concerned about inflation, the good news is that recessions are, by definition, deflationary.

Millions of Americans are wishing for lower inflation. Corporate leaders are wishing for lower interest rates. Congress may soon start begging for lower rates to deal with our insurmountable debt. The next president will likely pressure the Fed to lower the funds rate for the same reason.

All of them should be warned: Be careful what you wish for. There are always unintended consequences.