Inflation And Interest Rates Rise – Fed Loses Control

The inflationary storm front is here, and yet the Fed just hints at beginning to let interest rates rise in the future. The Fed’s only “action” so far has been multiple meek advances of the starting line. Revealed in meeting minutes was the latest: March – maybe. Meanwhile, inflation hawks are yelling, “Just do it!” while thinking to themselves, “It’s too late.”

But won’t the inflation rate decline once supply, shortage and Covid issues dissipate?

That hope might be why the Fed continues to hesitate. However, the underlying numbers say otherwise.

The 2021 CPI’s 7% inflation rate (5.5% excluding food and energy) helped awaken the problem in the minds of everyone, including the Fed governors. However, that rate does contain some bump-ups from the widely discussed supply, shortage and Covid effects.

To get behind those effects, examine the January 12 BLM news release. Table I shows the market basket component data – the weightings and price changes. The many areas with no unusual demand/supply effects show price rises centered around 4%. In other words, even when supply chain, production shortage and Covid absence problems are fixed, it doesn’t look like inflation will head back down to 2%.

Therefore, the Fed needs to take action to dampen the inflationary environment that is being aided by the Fed’s continuing lax, easy money policies.

The Fed’s cures are not wrong – They are just late in coming

“Tapering” means gradually cutting back on the Fed’s bond-buying. (Buying bonds increases the money supply because the Fed pays for the bonds by creating new demand deposits). Importantly, tapering means reducing “QE” (quantitative easing). It does not mean engaging in “QT” (quantitative tightening). Therefore, when the Fed finally gets down to zero bond purchases, it simply means the Fed is no longer easing – i.e., it has a neutral stance.

There remains a problem, though. All the inflation-friendly excess money created from the previous purchases that are in the Fed’s mammoth portfolio is still afloat in the financial system. That takes us to…

“Portfolio reduction,” which is QT. It is the reversal that extracts money from the financial system through both bond maturities and bond sales prior to maturity. The speed of that portfolio reduction will determine the effectiveness of the Fed’s inflation fight. A drawn out, weak plan will send a signal that the risk of higher inflation is here to stay.

Now to interest rates…

“Raising interest rates” also has two parts:

Reduced QE – The first move is in the quantitative easing area. It’s the rise from the abnormally low interest rates to market-determined, “normal” interest rates. When rates are once again normal, the Fed’s stance will be neutral. But that will not be an inflation-fighting posture. To get there, the Fed needs to engage in…

Increased QT – This tightening results from the Fed pushing rates above the “normal” interest rate level. Should or would the Fed do it? It depends on what the economic and financial environment is like when rates are normal again.

The frightening abyss the Fed faces

The actions above are easier for the Fed to talk about than to accomplish. Can the Fed maintain a sound financial system (the Fed’s main goal) while reversing fourteen years of excess? There are many reasons the Fed could ignite a financial firestorm that would spread to businesses and consumers. (A chilling scenario is what might happen when the same actions are taken by all the other countries that have followed the Fed’s easy money lead.)

Alternatively, by following a timid action plan, the Fed faces the prospect of runaway inflation and skyrocketing interest rates and all the ills that environment creates.

The bottom line: The Fed hesitated too long – Now the future looks darker

Think about this: Wall Street, banks, corporations, governments and all other organizations are filled with employees, managers and officers whose careers cover the past fourteen years. That means their understanding of “financial normality” is skewed by that long-term experience. Therefore, when conditions shift away from that Fed-created environment, the new, market-based reality will seem awry: wrong, risky and in need of a fix.

The result? A financial meltdown, or business as usual, but with adjustments?

Who knows? We have to wait and see. The first move in the coming saga is on the Fed’s head. The reactions to what they do (or don’t do) will indicate what’s in store.

From The New York Times (Opinion – Guest Essay by William D. Cohan – June 15, 2021), “The Fed Cannot Control Its Easy-Money Monster”

“It’s unclear whether the Fed has the will — or the ability — to end all this. Or if it even knows how to taper the bond-buying program without sending interest rates sky high, choking off the nascent economic recovery and freaking out everyone now addicted to low interest rates.”