Higher Interest Rates Will Cause Inflation

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Fed funds historical rates.

There was a time not that long ago when people believed higher interest rates slowed the economy, caused higher unemployment, dampened demand and put pressure on prices. The Federal Reserve in the United States and Central Banks around the planet held this belief tight to the chest. When the economy overheated, causing inflation to creep up, the Fed would start increasing interest rates until demand weakened as consumers faced higher borrowing costs.

The opposite also held true. Low interest rates were thought to spark strong economic growth as lower interest rates freed cash in family budgets for more spending while encouraging businesses to ramp up production with cheap credit. Since the Great Depression this theory held true and worked, even if slowly, in controlling economic activity. Then we had the twin recessions of the early 1980s.

All Downhill from the Peak

Stagflation in the 1970s proved difficult to contain. Two OPEC oil embargoes ramped up prices on oil, causing virtually all goods and services to increase without growing real wages to fund the price increases until wages started getting cost of living (COLA) increases each year. Inflation for the first time was chained with a weak economy.

High inflation encourages spending because the money in your pocket will be worth less in the morning. Businesses faced an opposite effect. Funding capital expenditures became more costly as Paul Volcker, the chairman of the Fed, racketed up interest rates at a steep rate. Killing inflation would require painful medicine. A weak economy was crushed. Housing suffered most. Mortgages rates were comfortably in double digit territory if you could get a loan at all.

The medicine worked. Demand dried up from the higher interest rates causing inflation to abate. It was the last time interest rate changes were so effective on economic performance.

Good Medicine Going Bad

Lower interest rates followed the brutal twin 1980s recessions. The stock market and economy rallied strongly. Pent up demand for housing lifted housing stocks and the building boom was off. The 1981 Tax Code overhaul gave businesses additional deductions for capital expenditures. It might be hard to believe expensing of assets worked this way. Back then the limit on Section 179 expensing of assets was raised from $10,000 to $25,000. Small business was ecstatic.

Increased tax deductions for capital expenditures caused a boom in production which required more workers. Increased production reduced inflation while employment skyrocketed. The world was good with only one warning cloud on the horizon: debt.

Current chairman of the Federal Reserve, Janet Yellen (left). Former chairmen (from second left to right) : Alan Greenspan, Ben Bernanke and Paul Volcker.

The tax cuts were funded with massive amount of new federal government debt. The annual federal deficit broke $200 billion and kept climbing. The credit card was getting a workout.

The smart money believed the excessive government spending would pay for itself with higher economic output increasing revenues. That promise has never been realized.

Lower interest rates were the perfect medicine for housing and housing creates lots of job, most good-paying jobs. By 1984 the economy was on fire with 7.4% growth that year while inflation was still easing.

The Fed was concerned by the heady growth and started increasing rates until it triggered selling by program trading. The economy barely missed a beat. In 1987 the economy expanded 3.5% and another 4.2% in 1988. The 1987 stock market crash be damned.

High interest rates took some time to reduce economic production, but not real long. Lower interest rates had an almost instantaneous reaction in the markets and marketplace. From Wall Street to Main Street, these were the good times.

The first warning signs something was fundamentally wrong showed up in the next recession which began in July 1990 and lasted for eight months.

Interest rates trended down from 1982 onwards. Periodic rate increases gave the economy indigestion causing the Fed to resume lowering rates again. Each peak in the rate cycle was lower and the lows were lower.

And the recoveries were longer, less steep and left more people behind as many high paying jobs never returned.

As the economy began climbing in April 1991 it was like watching water boil or grass grow. Growth was a heck of a lot slower than the liftoff from the 1982 recession. Some blamed it on the first Gulf War. There was merit in the observation. People stopped spending as they sat around the television absorbing their newfound entertainment: bloodshed.




One More Party

The slow growth out of the 1990/1 recession eventually broke loose with several years of 4%+ GDP expansion at the end of the millennium.

The terrorist attacks of 2001 set the tone for the next recession. President George W. Bush came on television and encouraged Americans to keep spending to show the terrorists our nation could not be deterred. The Fed added liquidity to the system (lowered interest rates) to unheard of levels. People began wondering what would happen when rates went to zero. What weapon to spur the economy would the Fed have then?

Lower interest rates did the trick. The 2001 recession was so short and mild the U.S. GDP still expanded 1% for the entire year.

But the economic expansion lower interest rates should have caused didn’t work as well this time. What was a concern in the post 1990/1 recession expansion turned into full-blown panic. The stock market lost half its value. The new money the Fed created stopped the pain on Wall Street. Main Street was not nearly as happy. Job growth was steady, but low. Only two years of the first decade of the new millennium had GDP growth over 3% in the U.S.

The stock market climbed from depressed levels and eventually made new highs. It was an unconvincing multi-year rally.

Then all the printed money that disappeared into derivatives and sub-prime mortgages came home to roost.

Current Economic Cycle

When the first cracks appeared the Federal Reserve had very few weapons in its quiver. Interest rates were already the lowest in recent memory prior to a recession.

Housing was in bad shape after the 2008 recession. My house could’ve used a few new shingles.

The 2008 recession was fast and brutal triggered by a cascading set of events which culminated in money-center banks and investment banking houses on the verge of collapse.  Low interest rates were not enough to stop the bleeding. Rates were now touching 0% and the economy was still in dire straits.

The Fed toyed with negative interest rates and the Japanese, Swiss, and European Union Central Banks all sent rates into negative territory where the borrower gets paid (!) to borrow money instead of paying to borrow. The lender took all the risk for a guarantee to lose money to boot.

In the U.S. the Fed started early in experimenting with alternative methods of pumping more liquidity into the banking system. It worked, sort of. The economic recovery from the 2008/9 recession never exceeded 3% in any calendar year, the slowest recovery in the nation’s history. The growth once again was steady, but painfully slow.

Wages were slow to increase as family budgets struggled to pay the bills. Low wage growth kept a lid on demand, inflation and job growth.

The current economic cycle started from the lowest interest rates in this nation’s history. The federal government kept spending at a rapid pace, all put on the credit card. The current federal national debt is over $20 trillion and growing at around a half trillion more each year. And we couldn’t manage 3% growth.

Where is the Inflation

There have been more predictions all the money printing would cause rampant inflation soon than there have been calls for the world ending. Prices fooled the experts. A basket of goods followed by the Bureau of Labor and Statistics (BLS) hovered slightly above zero with a few extended periods of deflation.

For eight years the Fed kept interest rates at 0% and the economy slowly clawed forward a few percent per year. And I think I know why.

Typical human blaming a bovine again.

Low interest rates were the medicine our parents and grandparents used to spur economic growth. But this time WAS different! Technology had finally advanced so far it was hurting the economy! Or more accurately, technology was increasing faster than demand could absorb.

Low interest rates no longer increases demand. Even businesses didn’t spend aggressively in the low interest rate environment until the last few years. What business did spend went further than ever. $4,000 computers two decades ago now cost under $1,000 and do a thousand times more and faster. Business spent less because the cost of capital expenditures had declined for many technologies and the cost of capital was nearly free. If technology costs would have remained unchanged, businesses would have created and capital expenditure boom.

Low interest rates after all these years seem to cause deflation instead of spurring economic growth like the good ol’ days. And higher interest rates, if the economic model is truly turned upside down, should cause the economy to overheat and inflation to expand. Here’s why.

New World Order

Keeping Interest rates so low for so long must have caused a few academics to rethink the classical model. Low rates caused bubbles and imbalances in the markets without any money trickling down to Main Street to create jobs and more demand for goods and services. It was a Wall Street pile-up where average people paid the price for the sins of a few with control over the newly created money.

It’s called pushing on a string. More money pushed into the banking system either didn’t find its way into the general economy or people refused to spend it if they did get it. This isn’t all bad if the savinga rate climbs as households save and invest a larger portion of their income.

This wasn’t the case either. The savings rate climbed slightly, but not anywhere near the levels money creation would dictate if the money weren’t spent. Where was the money going? Nowhere. The money supply was larger than ever as the Fed’s balance sheet bloated, but it all sat in money-center and Central Bank vaults around the world.

None of this matters since it was a wasted exercise carried out by central bankers. The money was created, yet most never entered the economy. No wonder the GDP was anemic.




Low Rates Caused Deflation, Now Rising Rates will Cause Inflation

Most businesses today have plenty of capacity. Here is an example from CNBC showing how low interest rates caused a glut in domestic milk supplies. Low interest rates allowed factory farms to add capacity at virtually no cost, over supplying the market and driving down prices. Industry after industry is in the same boat.

Low interest rates encouraged the over production. Higher interest rates will increase the cost of capital expenditures for businesses, eventually reducing supply and increasing prices. This is the opposite effect we might expect in the past. Higher interest rates usually slowed the economy and if raised far enough still will. But the initial effect will be to decrease supply as marginal production is taken offline.

The experiment isn’t over and my supposition could be 100% wrong, not that my batting average is any worse than that of economists. Interest rates are slow on the takeoff this economic cycle. Eventually a trigger point will be reached, causing the economy to overheat and prices to climb faster.

The higher interest rates will not work any better controlling inflation than low interest rates encouraged economic growth.

My concern is the trend. Since 1980, interest rates have been cycling lower. We went negative this time around and the fed funds rate peaked at 5.25% during the prior economic expansion. This cycle the Fed worries the current 1-1.25% fed funds rate might slow the economy. Crazy!

If lower rates don’t encourage inflation and rapid GDP growth, then higher rates probably will. At no time in history has this amount of money ever been created and hyperinflation hasn’t followed. There are no indications of rapidly increasing prices on the horizon, however.

Higher interest rates might do the trick or we could head still lower this interest rate long cycle. Only time will tell.

The earnings stream from a company is worth more in a low interest rate environment. If inflation starts the rear its ugly head the Fed will worry and jack interest rates, causing business investment to slow, marginal production to be taken offline, causing prices to increase. Remember, you heard it here first. And earnings are worth a lot less as rates rise.

Just a few things to consider as you plan the family budget.

 

Side Notes

Ever wonder how your favorite accountant takes notes for a new post idea? Below are my notes used to prompt the writing of this post, unedited. Writers might find the evolution of an article of interest.

The old world paradigm hasn’t worked for a few decades now. The old school says lower interest rates spurs demand and eventually inflation. At no time in history has so much money creation taken place for this long without a massive upturn in inflation. What is different this time?

Lower rates lead to a muted economic expansion with slow growing demand and modest job growth. The economy should have overheated by now. Why?

Instead of inflation, technology made it easy to increase production and the cost of capital was near zero encouraging this capacity expansion. Everything seems to be in a glut. From oil to food, there is plenty enough to satiate 100% of demand. Low interest rates now seem to fund capacity expansion faster than demand.

Higher interest rates will increase the cost of capacity expansion and will lead to higher interest rates.

What worked in the past is turned on its head! The Fed reduced rates for a decade and printed money with reckless abandon to further spur demand. It didn’t happen the way the textbook said it would. Higher rates, the traditional fix for inflation, may also have an inverse effect from the expected norm. When inflation does show up as the Fed increases rates the Fed may overreact and keep raising rates to kill inflation. It will work if rates go high enough. Demand can be quashed by high interest rates.

It would be easier and less painful to consider doing the opposite of what we always did in the past. It might just work this time.

https://www.cnbc.com/2017/09/22/dairy-glut-in-us-leads-to-problem-of-spilled-milk.html

 



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Keith Schroeder

13 Comments

  1. Mr. FarmCents on September 27, 2017 at 10:25 am

    Keith,

    Long time follower, first time commenter! I found this article very timely and insightful. I really like your thought process and think you have some sound logic behind it. I am a farmer in Texas and have directly experienced what you mention in the dairy example. We can do a lot more with less because of technology and are producing much more on less land. Most all in the farming community have fallen victim to the gluten of supply of agriculture commodities with little to no improvement in commodity prices on the horizon. We feel like we have to produce more and more with decreasing prices which worsens the supply problem. Being a younger farmer (30) I wouldn’t mind some experimentation by the Fed as I plan to be in the wealth accumulation phase for another 20 more years.

    Keep up the good work!

    p.s. Any agriculture specific or self-employed tax information is very helpful, although it may not be for the masses.

    • Keith Schroeder on September 27, 2017 at 10:55 pm

      FarmCents, I hope you clicked the link to the CNBC article. I found it enlightening and think you’ll feel the same.

      I could do a farm post, but the audience is much smaller. I might do it some day. The tax rules for farmers are significantly different and deserve an airing. Don’t wait for it, but don’t alos be surprised if one day a farm tax post finds its way into the alumni.

      • FarmCents on September 28, 2017 at 11:04 am

        Thanks for the response Keith. I married into this farming family and after living here for 5 years and talking to others, I have come to realize there is a huge need for tax and investment education in the farming community. One farmer told me he didn’t have access to any retirement plan because he was self-employed and I was shocked he didn’t know of SEP-IRA or Solo 401(k)s. Other than purchasing equipment most these guys take it on the chin pretty good when they make a crop. I have actually purchased a domain for talking specifically about FI in a rural agriculture message.

        • Keith Schroeder on September 28, 2017 at 12:47 pm

          Keep me in the loop, FarmCents. Would be happy to promote a farming FI blog, including a guest post.

  2. Bear on September 27, 2017 at 10:27 am

    The demographics are also against inflation; baby boomers are retiring and spending less money. Check out Harry Dent’s take.

    • Keith Schroeder on September 27, 2017 at 10:52 pm

      I agree, Bear. Demographics are against inflation so I’m not predicting a major push higher for prices. My supposition is that if low interest rates don’t cause significant economic growth and potentially inflation, then higher rates might. Perhaps higher interest rates will slow production growth faster than demand growth and that is where price inflation comes from.

  3. Matt Wootton on September 27, 2017 at 3:19 pm

    In my view, demographics is playing a huge role in the lack of GDP growth. It’s estimated that in the US, 10,000 baby boomers reaching retirement age every day. As people near retirement age, they spend less because they’re done with forming households, buying new furniture, getting braces for the kids, helping with college, etc. And it’s a double whammy because so many millennials have, willingly or not, delayed or outright rejected the traditional milestones of entering adulthood. When inflation was roaring during the mid to late 1970s, you had massive numbers of baby boomers entering the workforce, forming households and having kids. It’s not coincidental. Looking at the demographic projections going forward, I don’t see any reason to expect much upward pressure on rates, unless foreign governments/banks lose faith in our ability to control the federal debt and don’t want to own USTs any more. That is a scary thing to consider. Thank you, Keith, for your fine work. I am very appreciative for all the great information you’ve provided on this blog.

  4. FullTimeFinance on September 27, 2017 at 4:44 pm

    Interesting… What your describing is essentially what would happen in an unstable economy. Modern economics would postulate raising rates aren’t the cause of the inflation. Ultimately the fed rates influence the cost of capital but they don’t directly control it since there are other lending sources. But, the change in interest rates could shake the faith of those trading in dollars. Which can have an equal and potentially larger opposite effect. In essence what your postulating is a large scale loss of faith in our currency.

    • Keith Schroeder on September 27, 2017 at 10:48 pm

      No loss of faith in U.S. currency, FTF. The economy reacts differently depending on the circumstances. Money supply affects the economy in an agrarian society differently from an industrial economy than from an information economy. Interest rates can’t do what they did in the past because circumstances have changed. I think inflation will rise someday, but it will be short lived. Technology allows us to increase production faster, easier and cheaper than ever. It costs almost nothing for the necessities of life anymore. This post is not a warning; it is an affirmation of how far our species has come. The Gilded Age is now!

  5. Michael | The Student Loan Sherpa on October 2, 2017 at 8:58 pm

    Are you at all concerned that interest rates have been so low for so long that we won’t be able to respond to the next recession?

    • Keith Schroeder on October 3, 2017 at 8:48 am

      Michael, I don’t worry about interest rates. Rates are useful as a tool in calculating the discounted value of future earnings. In the 1950s rates were low for a long time and the entire 19th Century was marked with low rates in the U.S. with only a few spikes for economic or political events (ie. Civil War).

      The problem with low rates isn’t as a response to the next recession, it involves the creation of asset bubbles. Artificially low interest rates encourages risk taking at an unsustainable level.

      Low rates are not a problem. Monetary policy isn’t the only game in town. Fiscal policy could do more to spur the economy than monetary policy ever could. Congress has been lazy for 30 years and left the heavy lifting to the Fed. Next recession Congress may have to earn our vote.

  6. Dick on October 3, 2017 at 9:27 pm

    Hello,
    It is my belief things work differently these days because of the growing inequality in wealth and income. There might a lot of money in the economy but it is being hoarded by the few and not spent. It essentially is the same as having a lower money supply in the economy. Businesses can have access to cheap money and produce all kinds of goods and services but if there is no demand the economy will falter. The economy is demand driven and it is why constant attempts to revive supply-side economics never ends well. Money must get to the consumer one way or another. Eventually people spend all their money and then depend on credit. Once their credit limit has been reached new purchasing in over. Producers lower prices until they go out of business. The only solution I see is the politicians trying to accomplish is getting more money to the people that already have it. They will keep the money and produce nothing unless they see buyers. Money needs to circulate in an economy like blood needs to circulate in the body…or expect major health problems. Cutting taxes that benefit the wealthy will do more harm. I owe a big “Thank You” to my 1980’s economics professor. He told students how to prosper if Reaganomics took hold in society. He was 100% spot on. Yes, I am one of those money hoarders. Have good day.

  7. Dave on October 4, 2017 at 3:51 pm

    What will happen with housing? I’ve seen the bubble burst at least twice in my lifetime, and as an investor I’ve been really slow buying properties now. There’s so many people paying CASH for property you’d never think would warrant a CASH purchase. This of course is raising the prices of housing to the point where I’m not sure what to do. Lately I’ve been paying down debt….hard to find good value in housing today!

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