The Fed has a mandate to control prices, and based on that they should raise and hold interest rates high until inflation is back to its target of 2%. The stock market is generally priced as though nothing too bad will happen if interest rates are high temporarily and that inflation and interest rates are going to drop soon. But there are reasons to wonder how high rates will get and what damage it will cause.
Inflation may not get back to 2% in the next few years. There are lots of new reasons why inflation might be stubbornly high. For the last decade or two we have been producing lots of things very cheaply by producing everything wherever it is cheapest to produce, and we eliminated millions of dollars by purchasing supplies and parts just in time instead of buying and holding them in inventory. We lived in a low conflict world where everything could move pretty seamlessly around the world making all this possible. Basically, globalization, free trade, and the lack of conflict between major powers helped keep prices low.
Between the supply chain problems caused by the pandemic and the risk of depending on unfriendly countries like Russia and China for parts and labor, the new reality for manufacturing is that we need to build products where it is the safest, not the cheapest, and we have to hold materials in inventory in case there are hiccups in the supply lines. And this means almost everything is going to cost more to produce in the future than it cost in the past. If manufacturers are going to stay in business that increased cost will have to be passed on to customers.
Labor costs are higher than they were before the pandemic, and that may not change either. An aging world has a growing imbalance of younger working age people compared to a larger share of older people who aren’t working any more, a structural change that is worse now than in the last couple of decades. A chronic shortage of potential employees must result in higher average wages. And the cost of those wages will have to be built into the price of the products and services their employers provide.
These are just are some of the reasons to think inflation may be stubbornly persistent, and it may not go back to 2% for years, if ever. It may settle at a higher level like 3% or even 4% and refuse to go any lower no matter what the Fed does.
At the same time, higher interest rates are causing havoc in many ways. The regional bank crisis was caused in large part because banks made long term fixed rate loans and bought long term fixed rate treasuries and other debt at the low interest rates that used to prevail. If interest rates hadn’t gone up the banks would have been fine. They also would have been fine if rates briefly spiked then quickly returned to the previous low levels. But if rates stay high and banks need to liquidate their holdings to pay depositors who want to take their money elsewhere, the banks will take heavy losses on those investments. Many banks would be insolvent if they had to reflect the current value of their holdings. Even the giant, too big to fail, Bank of America has this problem!
The Fed could instantly fix the bank problem if it would lower interest rates back to where they were previously. The Fed has created some complicated programs to mitigate the immediate bank problem. But that mitigation may not continue to work in a world where interest rates don’t soon return to their previous levels.
Worse yet, the US government has a huge, and growing, pile of debt that it could barely afford to service at ultra low interest rates. Now that interest rates are spiking, the interest on all that debt is going to consume more and more of the federal budget. If interest rates stay high, a higher and higher percentage of government payments will be consumed by interest expense, leaving less and less to pay all the rest of the costs of the government.
The Fed could instantly reduce the scope of the government debt problem by reducing interest rates to previous low levels, but they can’t do that while inflation is hot.
If inflation just falls on its own to lower levels, the Fed can then justify dropping interest rates. Everyone is watching announcements of the CPI for evidence that inflation has been conquered. But some things go down and others go up. As noted above, I’m skeptical that it will drop back to 2%, with or without Fed intervention.
Another scenario is that higher interest rates trigger a recession, and the recession finally causes prices to drop. That would definitely give the Fed a reason to drop interest rates, but it would be at a huge cost to the economy and to most individual Americans.
A third scenario is that high interest rates are finally seen as a bigger problem than inflation is, and the Fed drops interest rates to protect the federal budget and the economy, and concedes that inflation will continue to be high, but that that is the cost of keeping everything else running smoothly.
A final scenario that I have been mulling over is the Fed will just stop here and hold interest rates at current levels while they wait for more data to emerge, but never see conclusive data to support making any more changes. In this scenario interest rates would stay at current levels and inflation would stay high as well.
In these scenarios, the hope would be that the economy would eventually adjust to the new realities of inflation and interest rates. That doesn’t seem totally crazy. Zero interest rates and zero inflation were not the norm except in the last decade or so. We’ve lived with higher for longer in the past, so it might be possible to have a thriving economy at higher levels. But everyone will have to adjust their expectations.