What if rate hikes make inflation worse?
It’s a question worth asking. Not in the sense that Recep Tayyip Erdogan might ask it, of course. But rather, out of respect for history, which teaches us that what seems counterintuitive, and thereby obviously wrong, in the moment, often appears obviously correct with the benefit of hindsight.
We needn’t travel too far back in time to find examples. Indeed, we needn’t deviate from the subject at all. In the early months of the pandemic, COVID was assumed to be a deflationary supernova. How could it be otherwise? Everything was closed. Travel came to a standstill. The many miracles of paper-ized, hyper-financialized commodities briefly brought us negative crude prices. The services sector was made illegal for all intents and purposes. And so on. Only massive fiscal and monetary stimulus rescued the world from a depression.
Looking back on it a mere two years later, it’s glaringly obvious how it was all a recipe for inflation. Had you suggested as much in late March of 2020, though, you’d have been branded a fool. Never mind that virtually all subsequent macro developments were effectively preordained, barring a nightmare scenario where successive mutations made the virus more deadly and more evasive vis-à-vis the vaccines we hadn’t made yet, but which we at least had the technology to produce, even if we didn’t know how long it would take or exactly how effective they’d be.
As we look ahead to 2023, I’ve repeatedly asked whether we’re walking into a trap, where that means the lagged effects of policy tightening wash over an already decelerating economy, while shellshocked policymakers too scared to pivot exacerbate the downturn by keeping policy restrictive — or turning the screws even further. I’ve raised that hypothetical even as I remain squarely in the camp who insists central banks do need to keep up the pressure, if for no other reason than to guard against the perception they’re derelict, which could precipitate a loss of faith in the currency. I think it’s also important to acknowledge that this isn’t an all-or-nothing sort of thing. If commodity prices fall and inflation normalizes “on its own,” as JPMorgan thinks it might, measured rate hikes in the background won’t hurt.
Or maybe they will — hurt, I mean. And not just in the sense that they could unnecessarily turn a shallow recession into a deep recession with very little to show for it in the way of incremental gains in the inflation fight. They could also hurt by choking off investment in projects and initiatives crucial to ensuring the kinds of supply shocks responsible for most (but certainly not all) of the inflation surge don’t persist or recur.
One person who’s concerned about that prospect is Joseph Stiglitz. “Raising interest rates doesn’t solve the supply-side problems,” he told Bloomberg, in an interview published on Wednesday. “It can even make it worse, because what we want to do right now is invest more in the supply-side bottlenecks, but raising interest rates makes it more difficult to make those investments.”
It’s a simple observation. But virtually everyone is giving it short shrift in 2022. And it goes beyond the notion that raising borrowing costs could stymie critical investment. It’s also possible that higher rates will simply be passed along to consumers (and renters) in the form of higher prices (and rents).
Q2 earnings season in the US was, in part anyway, a story about pricing power. While it’s true that credit card balances are rising rapidly, so is the cost of the goods and services charged to those cards. So, when we look at higher balances, are we seeing a strained consumer, or are we really just seeing an aggravated consumer paying higher prices? The former points to an imminent slowdown. The latter may not.
In that context, it’s notable (I think) that a simple ratio of revolving credit to personal consumption expenditures isn’t elevated by any modern standard. I should note that I penned this article on a laptop, feet dangling from a pier while trying (unsuccessfully) to stay ahead of a blue snow cone melting out over the edges of a styrofoam cup. Under those pressing circumstances, I admittedly didn’t spend too much time sorting out the best way to illustrate this particular point. What you see in the figure (below) is just what it says — monthly revolving credit and total PCE. You can take it or leave it.
Wage gains aren’t keeping up with inflation, but if inflation recedes even a little bit further, gains at the lower-end of the pay scale will once again outstrip price growth. Those are the consumers with the highest marginal propensity to consume, and at least at the aggregate level, it doesn’t appear that Americans are anywhere near maxed out in terms of the share of spending covered by revolving credit.
Eventually, consumers will buckle, but what if we’re underestimating their resiliency, resolve or simply their predisposition to keep spending until every piece of plastic that isn’t Saran Wrap is maxed out? If that’s the case, raising rates could exacerbate sticky inflation by compelling corporates to keep raising prices to consumers, who will then keep asking for higher wages.
Rate hikes, Stiglitz told Bloomberg, won’t address the proximate cause of the inflation problem in developed economies. The “real risk,” he suggested, is that raising rates will “make things worse.”
If we are asking the wrong questions about inflation, it wouldn’t be the first time. Not even in the last two years.
The reduction in housing starts has worried me about the future cost.
Yeah, I think housing is going to be one of the more stark examples of the dynamic described above. Housing needs more supply over the long-term and temporary demand destruction will only serve to stop housing starts that will take longer to put back into motion.
H-Man. Bianco Research put out a chart showing tightening cycles from 1973 coming forward. The scary part of the chart that was in every cycle, the rate of tightening was always higher than CPI. The article that used the chart noted that if that holds true for today, we have quite a ways to go before tightening ends with tightening at 2.75 and CPI over 9.
With all due respect to that guy, he and his charts get far too much attention in my opinion. What you’re describing is as simple as simple gets when it comes to charts. And the extrapolation is ludicrous. The idea that the Fed could make it to 9% (or 8% or 7%) is absurd.
When talking about inflation I am surprised that you never bring up the Baltic Dry index it know it is at crazy heights right now. It seems to me that if a manager is deciding to raise prices causing inflation that has to be part of it. Also the China tariffs is a part of it.
Rates at 3% or 5% are not high, by historical standards, or by business investment “hurdle rate” standards. It is hard to think of a bona fide operating business investment that flips from attractive to unattractive simply because cost of capital moves up 300 bp, especially with government incentives to be had. The investment decisions fragile enough to get tanked by +300 bp are the immensely long-duration ones familiar to stock “investors” paying 20 P/S and 5 PEG and real estate “investors” buying cap rates of 400 bp into a falling market – and squeezing money out of those paper “investments” and back into the real economy isn’t a bad thing. Companies looking at adding another cracker, pipeline, LNG tanker, assembly line, etc are not going to be blown off their capex course by a couple points higher rates. They might get blown off course by a recession that evaporates end demand, that’s a risk, but those decisions aren’t made based on short-term forecasts anyway. By the time the pipeline is operating, the recession of 202/23 will be in the past.
Another anecdotal data point from NYC: Out with friends tonight for a quick bite to eat in the Garment District (nothing too fancy) and there was nary a sign of demand destruction. The Fed has more work to do.
mfn – that’s a reason why the Fed might be goaded into overdoing a tightening. I recall similar situation in 2008. On the spot anecdotal oservations from many friends and colleagues living in wealthy suburbs and cities questioned increasingly ominous national stats, with comments like “I don’t see any sign of that around here.” Oops!
Your average Wall Street pundit and some Fed officials are lucky enough to live in those protected cul-de-sacs. So your call may well be proven right.
Lot of bifurcation going on. A very nice restaurant is on the ground floor of my office building. Dinner for two with a couple of cocktails, no wine = $300 type of place. Walked by yesterday and it was absolutely hopping, looked like Saturday not Wednesday.
You can see market implied futures curve for Fed Funds rate here
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Highest probabilities today at each Target Date:
Sep 2022 300-325
Nov 2022 325-350 tied with 350-375
Dec 2022 350-375
Feb 2023 375-400
Mar 2023 375-400
May 2023 425-450
Jun 2023 375-400
Jul 2023 375-400
You can also see progression of probabilities over past month.
Looking at Sep 2022, most probable has moved from 275-300 to 300-325 in past month
Looking at Feb 2023, most probable has moved from 325-350 to 375-400 in past month
Looking at May 2023, most probable has moved from 300-325 tied with 325-350 to 425-450 in past month
Looking at Jun 2023, most probable has moved from 300-325 to 375-400 in past month
So market still expects easing in mid 2023 but over past month whole futures curve has moved up – and for months in 2023 a good deal lot of that move was in the past day.
Good sharing, thanks. And pretty convincing counter argument above i must say.
Thanks! Very useful link.
This article makes the case why Powell and FOMC need to be “the adults in the room” while steering the fiscal ship through these precarious straits. My main (if not only) hope and confidence lies with Janet Yellen, whom I trust has Powell’s ear…
Stiglitz is right. The supply side needs the work, and it will cost money at a rising cost because companies have been dismantling supply chain mechanisms for years to pass the costs and short-term risks on to others, while watching short-term profits increase. Trouble is they also passed on their expertise, market leverage, and margin of safety as well.