John Phipps: The Link Between Rising Interest Rates and Inflation Isn't as Simple as You Might Think
USFR- John's World 4/29/23
Business websites and publications have it down to a formula. A big portion of their front-page coverage is anchored by a serious, but not necessarily consistent quote from a handful of economic shamans like Warren Buffet, Jamie Dimon, Larry Summers and Elon Musk. For the past year, it almost inevitably touched on inflation or interest rates or both.
This is the business equivalent of a fantasy league, and the Big Game they are all calling is the impending recession in the US. The causal link between the Federal Reserve discount rate and inflation is obvious to all serious armchair economists. Low rates encourage borrowing and spending, increasing demand. Therefore, it follows higher rates will lower demand and slow consumer prices. It just that simple…except for a few details.
First, and most importantly, there is a time delay between a Fed rate increase and any response in inflation. Hundreds of studies have been done, but there is a broad consensus around one year. That’s from a range of 9 months to 3 years.
Second, the effects intensify gradually, especially since the Fed has added steady jumps since it began in March 2022 – a little over a year ago.
Third, wild cards unrelated to interest rates. One factor that showed up for a lot of farmers – the supply chain still has kinks in it. Try ordering a new PTO shaft or planter monitor screen. When trade is physically stalled, the price of existing or old, fixable stuff increases, regardless of interest rates.
There are other delays built in, since all loan and deposit interest rates don’t immediately match Fed moves.The result is even though consumer and producer inflation have been slowly trending lower since about this time last year, as rate increases work through the system, there is a good chance of overshoot.
The next few months should be instructive. My guess is inflation will drift lower, perhaps even accelerate. The housing component of the CPI and PCE lags considerably and is just beginning to decline.
It is not inconceivable that the Fed will be reversing course abruptly and mirroring the upward spike with a rate decrease cliff to battle a looming recession. Regardless, we are just beginning to see results of their actions.
