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Inflation and the Fed

Groundhog Day at the Fed

Written by Geoffrey Pike
Posted November 20, 2015

There is a much-anticipated meeting in the financial world coming up on December 16. We will get to find out if the Federal Reserve will finally raise its key interest rate after being near zero for the last seven years.

In a way, it is like Groundhog Day — things keep repeating themselves. There were several Fed meetings over the course of 2015 where the markets thought it was finally time for a Fed interest rate hike.

Instead, the Fed has found every excuse not to raise the federal funds rate, from falling stocks or weakness in China to lower than expected growth or a continued strong dollar.

Most economists are in agreement now that the December FOMC meeting will finally be the time when rates go up. This is the overnight borrowing rate for banks, but it has an effect on market interest rates.

The Fed has already had a tight monetary policy for about a year now. The Fed announced an end to QE3 in late October 2014 after a period of unprecedented monetary inflation. Nonetheless, the monetary base has not been growing for a year now.

Still, interest rates have remained low. The federal funds rate has stayed near zero as banks have massive excess reserves piled up from the previous monetary inflation. Since the banks don’t need to borrow overnight to cover reserve requirements, the overnight rate stays close to zero.

The only way the Fed can feasibly raise the federal funds rate now is to raise the rate that it pays on bank reserves. In other words, when the Fed finally announces a rate hike, it will mean more money flowing to the commercial banks. It will be money to encourage them not to lend. So in this sense, it will be an even tighter monetary policy.

At this point, interest rates have ticked up a bit, likely in anticipation of a Fed hike. Is there anything that could change the minds of policymakers now?

Price Inflation

One of the major elements in the Fed’s decision making is price inflation. That is supposed to be the number one focus of the central bank, even though it is the central bank itself that creates inflation by creating money out of thin air.

I am no big fan of the consumer price index (CPI), as it is a government statistic with several biases. No matter how you cut it, though, it is impossible to accurately measure price inflation, especially when different people buy different things and in different quantities.

Overall, I believe that the CPI tends to be understated if anything. It is supposedly near zero. Social Security recipients are not getting a cost-of-living increase in 2016.

Many people believe that the only negative consequence of monetary inflation is that it can lead to higher prices. But this is just one possible consequence. When money is created out of thin air, it redistributes wealth and distorts savings and production. It leads to a misallocation of resources.

And although the CPI numbers are showing very little price inflation, tell that to the struggling American middle class. Can anyone honestly claim that wages are keeping up with overall prices? Aside from gasoline and some electronics, what other major goods or services have become cheaper over the last year?

Meanwhile, for people getting a cost-of-living raise at their job, this is mostly being eaten up by just health insurance premiums alone. It doesn’t even take into account things such as food, rent, property taxes, furniture, or a whole host of other things.

It was recently reported that there was a bit of a spike in medical care costs and rents in October. While we usually discuss health insurance premiums, the actual cost of medical care — which is obviously related — is also a major factor. This not only drives insurance rates higher, but it means more out-of-pocket costs for consumers as well with their deductibles and coinsurance.

In terms of rent, there is nothing that can impact people more. Food and shelter are the basic necessities of life. The only people not impacted by higher rents are those who already own. But even here, property taxes have gone up for many people. And for those buying a house, prices are also up in most regions.

I believe it is this subtle price inflation (although not so subtle in health insurance) that is making the American middle class struggle. This is a major reason why Donald Trump and Bernie Sanders have done unexpectedly well in the polls. They may not have the right solutions, but at least they acknowledge the economic pain of the middle class.

If the CPI is off by just a little, this can be a big difference over the course of a few years. If someone is getting a 2% raise every year and price inflation is actually 4%, then that person is losing 2% per year in real wages. Compounded over the course of a few years, the person’s wages are down by 10%.

CPI Usefulness

Despite the flaws of the government’s CPI data, it can still serve a purpose. First, it is useful in tracking trends. The latest report shows that price inflation turned positive for the first time in three months. For October, it was up 0.2%. One month does not make a trend, but we will be able to see if price inflation is accelerating over the next few months.

A second reason to watch the CPI is for the simple fact that the Fed uses it. While the Fed’s monetary inflation does damage no matter what, the Fed members think they get a free pass as long as price inflation remains relatively low. In some ways, they are right.

Since those who dictate monetary policy are watching the CPI as a guide, then we should pay attention to it, too.

Another useful statistic is the median CPI as published by the Cleveland Fed. Using the median number takes out the bumps. It is much more consistent. Interestingly, the median CPI had been running at 2.3% year-over-year for several months in a row. In the last two reported months of September and October, the median CPI rose to 2.5%.

With all of this data coming in showing a slight uptick in price inflation, it makes it all the more likely that the FOMC is going to finally follow through with a rate hike in its December meeting.

We still have a little over three weeks until the meeting, so things can happen between now and then. There could be another downturn in stocks, a major bankruptcy, or trouble in Greece. There always seems to be an excuse that pops up to delay a rate hike.

Lower Inflation and Higher Rates Are Not Inevitable

As the consensus grows that a rate hike really will happen this time, we have to believe that the first hike is already built into the market. As mentioned, interest rates have ticked up. The 10-year yield has risen from around 2% to about 2.3%.

It would seem inevitable that, with the Fed looking to hike rates at its next meeting and possibly future meetings, we will see market interest rates go up more and price inflation likely go down.

But in our crazy financial world of today, we shouldn’t assume these things.

First, it is technically possible for the Fed to actually create more money out of thin air while still raising interest rates. And higher interest rates do not automatically mean lower price inflation. All we have to do is look at the 1970s when there were double-digit interest rates and a double-digit price inflation rate.

In terms of interest rates, we also shouldn’t assume that higher Fed rates means higher market rates. This is a bit counterintuitive, but think about the possibilities with the Fed raising its key rate.

The Fed’s biggest fear is that it hikes its rate and there is an economic downturn. It would probably get blamed for the downturn then.

But if we are facing a recession and falling stock prices, where do investors go for safety? Whether you personally think they are safe or not, many seek to lock in rates with U.S. Treasuries. As investors buy bonds, this would actually drive down market interest rates.

Therefore, as strange as it sounds, the Fed’s increasing of interest rates could actually lead to falling interest rates.

We live in unprecedented economic times where up is really down.

The slightly higher price inflation numbers are pointing to a Fed hike. The bigger question is what a Fed hike is going to mean for the economy.

Until next time,

Geoffrey Pike for Wealth Daily

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