The Federal Reserve’s interest rate rise from 0.25% to 4% was remarkable, but not because the 3.75% increase was historically large or fast. Unlike times past, rates had to climb out of a 0% basement. With that accomplished, we can now view 4% as the new ground level – the place from which the interest rate rising begins to bite.
Why is 4% a ground level?
To answer that question, let’s review how capital markets set interest rates when the Federal Reserve is not overriding the process.
In capitalism, the price of money (the interest rate) is based on inflation risk (of purchasing power erosion), maturity risk (of adverse future developments) and credit risk (of borrower inability to make payments).
Note: This combination of factors determines the “normal” interest rate level. It can be altered by money demand-supply imbalances, government regulations and, of course, Federal Reserve actions.
The Fed’s 4% rate (the upper limit of the Fed’s current Federal Funds range of 3.75%-4%) is the primary basis of the 3-month U.S. Treasury Bill yield. Because a quarter-year is often used as a one-unit holding period, the 3-month T-Bill is viewed as “riskless” as to maturity and credit. That leaves compensation for loss of purchasing power as the operative rate determinant.
And so, the question: What is the right inflation rate?
Unfortunately, the answer is a perfect example of the age-old problem:
- The data you have is not the data you want
- The data you want is not the data you need
- The data you need – you can’t get!
Start with what we need: The general price level rise rate caused by the currency’s loss of purchasing power. (This is referred to as “fiat money inflation,” meaning a “paper” money’s loss of value.)
The problem is the general price level rise is hidden in all the price measures by noise – other price changes caused by things like unusual events, shortages, gluts, and demand-supply shifts and imbalances. Furthermore, the underlying general price level rise does not occur at a steady rate. Especially with higher inflation, like now, price rises can become volatile due to inflation-driven actions: market-based pricing (e.g., commodity hoarding), buyer demand actions (e.g., brand-product shifts), producer pricing-actions (e.g., product changes), retailer pricing-actions (e.g., own-brand strategies), import-export actions (e.g., trade shifts), and political actions that affect pricing (e.g., tariffs).
However, all is not lost. By selecting one inflation measure, and then adjusting for unusual price changes among its components, a rough approximation can be made.
The most popular measure is the Consumer Price Index (CPI), built on a basket of consumer goods. It has been around for decades and is well constructed. Additionally, it meshes with the common desire of people to understand inflation.
This time around, the challenge is to adjust for large, unusual effects: From Covid-driven alterations to chip shortages to high oil price volatility to house shortages to vehicle shortages to employee shortages to Ukraine-Russia war effects.
While precision is unavailable, we can get a decent approximation that is much better than the media’s process of cherry-picking the scariest number. Remember 9% and 8.2%? They were gross overstatements.
So, what is a better number? As I have discussed previously, 5% looks to be a reasonable fiat money inflation rate. To avoid a false look of precision, let’s make that a range: 4% to 6%. The decline from the higher CPI rates has begun, and we could see a move into this range in the months ahead.
Moreover, there is a good possibility that the inflation rate and the interest rate could meet in the first half of 2023. After all, the interest rate is already at 3.75%-4% (expected to be raised to 4.25%-4.5% in December), and the October “core” 12-month CPI (all items less food and energy) rate declined to 6.3%. Such a meeting of the two rates would be momentous. It would signal a return of interest rates’ relationship to inflation that existed before former Fed Chair Ben Bernanke began his 0% interest rate experiment in 2008. This graph shows that forever-before relationship…
While the potential rate meeting brings up the good news of reaching a fulsome interest rate, it also introduces the bad news of a tight money environment (compared to the past fourteen years).
From “passive” to “active” tightening
James Bullard, President of the Federal Reserve Bank of St Louis, frequently provides valuable views based on wisdom and common sense. Here are his latest statements, as reported by AP (Nov. 17) in “Fed official suggests substantial rate hikes may be needed.” (Underlining is mine)
“The Federal Reserve may have to raise its benchmark interest rate much higher than it has previously projected to get inflation under control, James Bullard, president of the Federal Reserve Bank of St. Louis, said Thursday.
“Bullard’s comments raised the prospect that the Fed’s rate hikes will make borrowing by consumers and businesses even costlier and further heighten the risk of recession.”
“Bullard suggested that the rate may have to rise to a level between 5% and 7% in order to quash inflation, which is near a four-decade high. He added, though, that that level could decline if inflation were to cool in the coming months.
“Loretta Mester, president of the Cleveland Fed, echoed some of Bullard’s remarks in her own speech Thursday, when she said the Fed is ‘just beginning to move into restrictive territory.’ That suggests Mester, one of the more hawkish policymakers, also expects rates will have to move much higher.”
The bottom line – As capitalism’s strengths return, investors will turn to reality investing
We can now set inflation aside because that battle is on and understandable. What’s important for investors to focus on is that the many years of excessively cheap money have ended. Now begins the move back to reality capitalism, with investors returned to their rightful, catbird seat.
When investors can earn a meaningful, safe interest income, they take on risk only if it offers full compensation: Higher bond interest spreads and higher stock dividend income and/or capital gains potential – all sitting atop inflation-matching (or beating) safe income yields.
So, start focusing on reality investing to take advantage of the shift back to healthy, winning investing principles. Start by digging out those ignored “grandparent’s” bond and stock investing books. They explain the challenges that investors face and the proven strategies for investing success.
Importantly, expect everyone’s 14-year curated beliefs and views will be turned upside down (and that includes in Wall Street). We’re already seeing shifts – like the mighty tech leaders losing their positions atop the forever-best pedestal. For example, from The Wall Street Journal this weekend (Nov. 19-20) in “Twilight of the Tech Gods”
“The myth that startup founders possess extraordinary powers harms everyday workers and investors.”