It’s a mug’s game to be forecasting inflation, but it’s starting to look like the Federal Reserve may have to tighten monetary policy sooner rather than later to get it under control.
Last week, the May core personal consumption expenditure price index rose 3.4 percent from a year ago, the fastest increase since April 1992. This is the key inflation indicator the Fed uses to set policy.
Though the reading could add to inflation concerns, Fed leaders, backed by an army of economists armed with models and data sets, insist the current situation will subside as economic conditions return to normal.
They continue to argue that inflation has spiked recently because of supply chain disruptions that have left manufacturers unable to keep up with the escalating demand that has accompanied economic reopening. Soaring real estate prices also have played a role, along with the natural bounce back after plummeting demand depressed prices last year.
Economist Friedrich von Hayek once likened controlling inflation to trying to catch a tiger by its tail: an impossible task with unpleasant consequences for the economy and for personal finances. Judging by the most recent inflation reading, the cat may be already out of the bag.
As William McChesney Martin, the Fed chair from 1951 to 1970, said in a 1955 speech, the job of a central banker is to “remove the punch bowl” before the party gets out of control.
This metaphor referred to a central bank’s action to stop flooding the country with easy money and ultra-low interest rates. There is no silver bullet, magic wand, or get-out-of-jail-free card when dealing with inflation.
The federal funds rate is the most important benchmark for interest rates in the U.S. economy and it also influences interest rates throughout the global economy. Raising it may impact several key economic players.
Banks will be copacetic with higher interest rates. They will see an increase in their net interest margins, an important measure of banks’ profitability. Net interest revenue refers to the difference between interest earned on loans and interest paid on deposits. They will charge more interest for their loans, while deposit rates increase more gradually.
Life insurance companies will also welcome higher interest rates. Most insurers earn substantial income from investing premiums and favor high quality bonds whose yields have plummeted in recent years in the sustained low interest rate environment.
Rising interest rates negatively impact the stock market because higher rates make it more expensive for companies to operate and borrow money. That reduces profitability, which in turn hurts the value of company stock. Also, when stocks decline, investors may move into bonds to take advantage of the higher interest rates.
Bonds are particularly sensitive to interest rate changes. When the Fed increases rates, the market price of existing bonds declines. New bonds come into the market offering investors higher interest rates, which causes existing bonds with lower coupon payments to become less valuable.
While higher interest rates are bad for borrowers, they’re great for folks with savings accounts, certificates of deposit, and money market mutual fund accounts who currently earn a hair above nothing on these accounts. Conversely, a hike in interest rates adversely impacts consumer credit such as student, auto and personal loans, lines of credit and credit cards.
As for the housing market, rising mortgage rates will hurt home prices, since higher interest rates may force borrowers to buy a cheaper house to maintain the same monthly payment. Higher mortgage rates may have the biggest impact on the lower end of the housing market.
Stepping back from the immediate issue of inflation or deflation, it is useful to recall that a consensus of British economists predicted that Margaret Thatcher’s economic policies would be disastrous. As her first chancellor of the exchequer, Geoffrey Howe, said, “an economist is a man who knows 364 ways of making love, but doesn’t know any women.”