Inflation, Interest, and the Fed

Interest rates play a crucial role in the economy, influencing savings, investment, consumption and overall growth.  Central banks around the world cut benchmark interest rates sharply following the 2007-09 financial meltdown that  tanked the global financial system. In many cases, the nominal interest rate was cut to zero, close to zero or even negative territory.

It was thought that these aggressively low interest rates helped stimulate economic activity, although there remain uncertainties about the side effects and risks. 

Distressed, or “Zombie,” companies feasted on cheap credit. These firms tied up resources that could have been better allocated to more productive and efficient businesses, hindering overall economic growth.

For example, companies such as Bed Bath & Beyond earned just enough money to continue operating, but were unable to pay off their debts as interest rates rose.  As rates have risen, many of the loans banks made to these firms have turned out to be stinkers, as borrowers miss payments or default. 

Indeed, cheap credit, by way of low interest rates, was allowed to persist for an improbable 14 years – much too long in the minds of many analysts.  What was initially seen as a blessing turned out to be a curse. 

When continued for too long, cheap credit effectively inspires excessive borrowing – some of it speculative.  And bubbles do eventually burst. 

A lot has happened since the 2007-09 financial crisis. Recently, inflation has returned with a vengeance.  The Federal Reserve and other central bankers are trying to stop surging prices by raising short-term interest rates, which is not necessarily a boom for the stock market or the economy.

Rising interest rates help control demand for credit, soften growth of the money supply and therefore help control demand.  In theory, higher mortgage rates may slow housing price inflation and help make property more affordable over time. 

Others argue that today’s rate hikes threaten to push up tomorrow’s housing costs amid high prices for materials and loans.  This creates a threat of future housing shortages that could lead to more inflation.

High interest rates prevent a misallocation of capital goosing the price of the riskiest assets in the shares casino.  Then there are investment projects, often vanity projects, that only proceed because of cheap capital. 

As interest rates rise, they incentivize savings in contrast to the recent near-zero interest rates that made savers – including many retirees – feel like fools.  

Finally, high interest rates give central banks room to cut interest rates in the event of a negative external shock. In sum, they act as a deterrent to excessive borrowing and spending, curbing inflationary pressure and preventing the formation of bubbles.

But higher interest rates also bring with them the risk of significant slowdowns in consumption.  They might choke off much needed business investment in new home building and renewable energy capacity, for example. 

Rising interest rates may cause the dollar to appreciate, making exports less competitive and leading to an export slowdown and perhaps a worsening trade deficit.

Higher interest rates certainly make government debt more expensive, sending debt costs soaring and eating up a bigger share of public budgets.

Finally, higher interest rates might lead to a broad-based economic slowdown that could hit stock prices, pension fund assets, and dividend incomes.

In recent months, inflation has been as persistent as gravity.  A cold dish of truth is that it is unclear when prices will moderate.  The Fed took a break from raising interest rates at its June meeting after a string of 10 consecutive rate hikes in just over a year. Still, the benchmark rate could go a bit higher in the near future.  

The Fed is taking some time to assess the effects of its prior rate hikes on inflation and the overall economy, as well as the impact of other economic activity – namely the collapse of three banks this spring.  Improvisation is clearly the order of the day.

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