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Rate Hikes: Why You Shouldn’t Fear Inflation

 -- Published: Sunday, 12 March 2017 | Print  | Disqus 

By Samuel Rines and Katherine Morille

In recent weeks, we’ve been bombarded with news headlines like, "Goldman, JPMorgan Boost Rate Hike Expectations on Hotter Inflation” and "March Fed Hike in Play for Trader After Inflation Surge.

Call me a spoilsport, but the fact is that the rhetoric surrounding interest rate hikes is far more inflammatory than the reality.

Over the past several years, markets have responded to low interest rates by pushing asset prices higher. Ostensibly, the purpose was to spark some inkling of inflation. Despite these efforts, rampant inflation has not materialized, but a growing chorus of forecasters see inflation pressures emerging.

Even if that’s true, it should be welcomed… not feared.

One possible source of sustainable inflation pressures would be wage growth. However, for nearly 30 years, wage growth has been more or less non-existent—in part, as a result of a shift to service jobs and away from manufacturing and, in part, because we have entered an age in which automation is increasingly replacing human labor.

We are also in the midst of a demographic change of huge proportions: Baby Boomers are reaching retirement age and the younger Millennials are taking over. At least, that’s the theory. In practice, the process is slow, and Boomers are working longer than their parents did. The knowledge, or human capital, built up by the Boomers often results in higher salaries, and Millennials simply can’t replace them.

Since the financial crisis of 2007–2008, most monetary policy changes have been driven by hard data. So if wage growth is unlikely to be the force behind inflation, what will drive it?

Most people expect that “Trumponomics” will pick up the slack. From tax breaks to a $1 trillion infrastructure plan, America’s new economic reality looks to be brighter than it has in recent years.

But again, this is transitory. It will take the economy years, not weeks, to fully digest Trump’s policies. And the most inflationary aspect of the potential plans—fiscal spending—is likely to disappoint in both size and scope.

The FOMC agrees that there’s a higher risk to the economy due to uncertainty surrounding the fiscal package. This uncertainty means the Fed will be patient in altering policy. The risk of disappointment is high, which could cause inflation expectations to drop—something the Fed does not want to happen.

So what is driving all of this supposed inflation increase?

The rise in oil prices (and therefore, gasoline prices) is certainly a factor. But rental prices for housing have been rising consistently as well. In fact, the 3% annual gain in rents consistently accounts for more than one-third of the measured inflation.

The Fed sits between the proverbial rock and hard place. If it delays hiking interest rates for too long and inflationary pressures build, it could mean that ultimately, it would have to raise rates much faster. On the other hand, it doesn’t want to slow down the hard-won inflation it has already created. Waiting too long may be less of a consequence.

Federal Reserve Bank of Boston President Eric Rosengren recently stated that keeping rates at extremely low levels could cause the economy to overheat and that rising inflation showed the economy was strong enough to digest these necessary rate hikes. Without significant ammunition, he said, monetary policy would have little room to stimulate the economy in the next economic downturn.

Yet despite needing the leeway to move, the Fed is still on track to raise rates slowly.

In mid-February, Cleveland Fed President Loretta Mester said that she sees inflation moving toward 2%. In my mind, where the economy is now argues that we should be bringing the rate up,” she said. “But no one on the Fed, I would say, is thinking of precipitously raising.”

This is critical to understanding how the Fed is going to taper off stimulus. The Fed’s “summary of economic projections” (its best guess of what the economic data will be) has been fairly close to the incoming data. Without a Brexit-type event, the Fed is likely to get its projected two or three hikes in.

All of this translates into higher inflation and higher interest rates, which give the Fed more ammunition to combat the next economic downturn. At current rates, its monetary-policy firepower is greatly limited.

So there’s no doubt that interest rates are going to rise, regardless of whether it is in March or June. And that’s a good thing because this gradual path of increases will lead to a better, longer-lasting outcome in terms of expansion. At current rate levels, there is simply not enough room to move interest rates around if a downturn requires stimulating the economy.

Without the ability to create stimulus, even non-traditional policies—such as quantitative easing—could be rendered ineffective. The US is close to full employment, and inflation is nearing its goal.

A strong economy doesn’t need the same stimulus as one that is struggling to pull itself out of a recession. The Fed must keep enough ammunition to adequately respond to an economic crisis, especially given international and domestic fiscal uncertainties.

Therefore, the fact that the Fed is moving should be celebrated, not feared.


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