Interest Rate Cuts and Inflation: What's Really Going On?
For more than two years, we've heard a steady drumbeat of news highlighting inflation and its impact on interest rates. The correlation seems clear, but the issue is actually more complex.
On the surface, the relationship between interest rates and inflation is obvious: When prices get too high, the Federal Reserve counteracts by raising target interest rates. That makes borrowing money more expensive, which causes individuals and businesses to contract spending. That, in turn, lowers demand and, in theory, prices.
As a very simplistic, ground-level explanation, that fits. However, much as the calm surface of a lake hides an infinitely complex ecosystem below, there’s considerably more to the story. Failure to consider the complexities behind the surface explanation is why we’ve seen several predictions in late 2023 and throughout 2024 that have not come true, such as the idea suggested by well-respected financial organizations that the Fed would begin lowering interest rates early this year.
Different inflation metrics
A key factor in many of these overly optimistic predictions is that they’re based on the wrong metric. Almost any news story about interest rates will mention the Fed’s target of 2% inflation year-over-year. However, the important distinction often not mentioned is that the inflation statistic the Fed is considering is not the inflation statistic reported in most news stories. Those stories highlight overall inflation, the Consumer Price Index (CPI). The Fed usually determines interest rate strategy by also examining metrics such as the core Personal Consumption Expenditures Price Index (core PCE).
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Among other differences, core PCE considers prices throughout the economy regardless of who made purchases at those prices. Core PCE includes the price of medical goods and services, such as doctor visits, covered by personal insurance or Medicare. CPI considers medical purchases made only by individuals, such as buying over-the-counter pain relievers at a drugstore.
The core PCE also doesn’t include energy or food prices because those prices tend to be more volatile than other categories, which makes snapshot views a less reliable indicator of overall inflationary trends. For example, when Russia invaded Ukraine in 2022, gas prices skyrocketed. That situation considerably impacted the CPI, but wasn’t by itself an indication that corrective action was appropriate: More important, it wasn’t an indication that corrective action would work.
That gas price spike was not caused by an increased demand for fuel. Instead, it was due to speculation that Russia’s war would impact the fuel supply. Because raising interest rates is a tool for reducing demand, it would be inappropriate as a tool for reacting to price fluctuations that aren’t tied to demand.
That’s an example of why core PCE is seen as a better indicator for deploying interest rate increases or decreases. It’s also an example of why so many predictions as to what the Fed will do with interest rates are off base.
Ultra-low interest rates are unlikely
Timing aside, many are hopeful that at some point, the Fed will lower interest rates once again to near 0%. However, the likelihood of that happening absent a fairly severe economic stumble is low, in large part due to one simple reason: If lowering interest rates is the only tool the Fed has to avert or reverse an economic downturn, it’s unwise to set target rates anywhere near the lowest they can go when we are not experiencing a downturn. In other words, setting the target rate to 0% now would leave the Fed no maneuvering room to address a slowdown in the future.
The Fed is walking a tightrope: On the one hand, it needs “dry powder” to stimulate the economy if needed. On the other hand, it’s undesirable for the dry powder that is higher interest rates to turn the economy toward recession. In that balancing act, the Fed is attempting to do something that has been seen as nearly impossible: beat back inflation without sending the economy into a recession — the “soft landing” scenario. So far, this seems to have been successful.
The last time inflation soared, in the 1970s and early ’80s, the Fed raised interest rates to curtail it. However, once inflation began to drop, the Fed decreased rates too soon, resulting in what’s been dubbed a “double-dip” inflationary period. By freeing up capital, the Fed inadvertently allowed smoldering inflation to ignite again.
That is a situation current Fed Chairman Jerome Powell is determined to avoid, which is why the Fed has been comparatively slower to lower interest rates. This reluctance to potentially cause another double-dip scenario is complicated by another factor: As a tool for influencing inflation, target interest rates are no longer the sledgehammer they once were.
When interest rates climbed in the 1970s, the result was a considerable reduction in the amount of funds available for individuals and businesses to borrow. In many cases, banks, which themselves frequently borrow money in order to lend it out, weren’t able to borrow enough money to lend; the flow of money was reduced to a trickle with the end result being inflation that was once again under control.
Reduced rate effectiveness
The modern economy is different. Following the financial crisis that began in 2007, U.S. monetary policy shifted to a quantitative easing plan in order to stimulate the economy. By flooding the banking system with money, quantitative easing maintains liquidity even in situations where liquidity would otherwise be constrained.
This means raising target interest rates doesn’t necessarily have the same impact on how expensive it is to borrow money: If the bank doesn’t have to borrow money from the Fed in order to lend it to you, but instead can borrow from other cash-flush banks at lower interest rates, it doesn’t have to pass that extra interest on to you in addition to the interest it charges.
Quantitative easing did what it was supposed to do in the 2007 downturn: It kept us from entering a depression rather than the deep recession we experienced instead. However, it wasn’t deployed as a one-time-use program; rather, it’s part of policy now. This can cause concern if not properly managed.
Increased market impacts
At the same time that interest rates have a lesser impact on inflation than they once did, they also have a more significant impact on the stock market. A low-interest-rate environment is good for the stock market because it forces investors who want a meaningful return on their money to enter the market. If the target interest rate is near 0%, the rate consumers can get on savings accounts, CDs and other interest-based investments will also generally be near 0%. Since such low returns won’t keep up with inflation, in a real sense you are losing money by keeping it in a low-yield account. You’re therefore more likely to decide to invest it somewhere with higher potential return, such as the stock market.
This, of course, means the market will react whenever the Fed makes a target interest rate decision. If the Fed is predicted to cut rates, the market will frequently become optimistic and rise in anticipation of greater investment. If the Fed then fails to cut rates, the market often reacts negatively.
Refining predictions
A better practice than making predictions based on CPI trends or, as is often the case, outright assumptions, is to consider the Fed’s Summary of Economic Projections, colloquially known as the Dot Plot. This document, updated regularly, outlines the future target interest rate each Fed banker believes is best policy. Especially under Powell, the Fed’s decision-making has tracked the Dot Plot fairly closely, meaning studying it can give you an idea of potential future interest rate decisions.
All this is to say there’s quite a bit more going on beneath the surface than the common public narrative of a direct link between CPI and interest rates. To make sound financial decisions, it’s important to have a deeper understanding of the mechanisms impacting your finances and the economy as a whole. Of course, if finance is not your vocation, it can be difficult to keep up with all the moving parts — it’s therefore always a good idea to work with a financial adviser who can consider these factors and more before recommending a course of action. (For some tips on how to cope with inflation, see the article How to Deal With Inflation: Advice From a Financial Adviser.)
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Jared Elson is a Series 65 Licensed Investment Adviser Representative (IAR) and the CEO of Authentikos Advisory. Following a 10-year career with Yahoo, Jared identified an acute need for sound financial counsel in the tech industry and has excelled in giving tech professionals the tools they need to grow and preserve their wealth.
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