Feb. 1, 2023

Is the Fed Winning Its Battle With Inflation?

It may be the largest economic brain trust in the world. The Federal Reserve Board employees over 400 economists to help present an incredibly

diverse yet precise picture of our economy. Each economist has a PhD., a requirement, no doubt, for the position. And each Fed Economist has a specific field of concentration.

All that analysis, plus an incredible about of data collection, and computer crunching will go together to guide the Federal Open Market Committee in making its latest interest rate decision today. The Fed will flash its interest rate announcement across computer screens worldwide at precisely 2 pm eastern time.

Usually, the Fed raises interest rates by one-quarter percent or more. For the first time in my memory, the Fed may raise interest rates by only 1/8th %. A fractional hike which may indicate a lack of conviction on the part of the Fed.

It's been 10 ½ months that the Fed has been raising interest rates. A year ago, before the Fed started hiking rates, the Fed Funds rate, (the Fed's short-term interest rate) stood at just one-quarter percent. Today it stands at 4 1/2% and is likely to go even higher after this afternoon's announcement.

Managing interest rates is the Fed's most influential and visible of all its monetary tools. The Fed Funds Rate sets almost all short-term interest rates. Interbank loans, for instance, sizable corporate financing, and perhaps even your credit card, as well as other financing, all follow the Fed Funds Rate.

Most importantly, conventional economic thinking is that as the economy slows, so too will Inflation. The Fed is raising interest rates currently to tamp down Inflation. As interest rates rise, economic activity slows because borrowing cash becomes more expensive, and loans often become more challenging to obtain.

Its been the conventional way of thinking of the Fed since its founding 110 years ago. Based on that thinking, the Fed must feel rather good because Inflation has declined.

As we've discussed, there are several measures of Inflation. The better to keep those 400 Economists busy. The most popular measure of Inflation is the Consumer Price Index. According to this standard, CPI Inflation has declined by about 2% since the Fed began raising rates.

On the other hand, the Fed's favorite measure of Inflation is Personal Consumption Expenditures Inflation or just PCE Inflation. This measure has declined about double CPI, or about a 4% decline.

So the Fed raises interest rates by 4%, and Inflation, depending on how you measure it, declines by somewhere between 2% and 4%.

But ringing in your ears is likely a lecture you heard from a science or math professor that said that just because two events happened together doesn't mean that one caused the other. In other words, correlation is not causation.

So, let's a look at our first chart. You'll notice that the Fed has been very consistent, steadily increasing the prevailing interest rate. But Inflation has not been steady. It's been all over the board, with significant increases in March and June but a big drop in July.

There isn't any relationship between Inflation and interest rates, at least not in these short-term charts. These two factors, interest rates, and Inflation, appear to be independent of one another.

There may be some other factor behind the scenes that better correlates with Inflation. A factor that we would expect to see rising when Inflation rises and falling when Inflation falls.

The Price of Gasoline in the following chart reveals that over the past year, there has been a close correlation between the price of gasoline and Inflation; gasoline and Inflation peak in March, June, and October and fall in July 2022. Every time the gasoline price went higher, so too did Inflation.

I'm sure this comes as no surprise to you. You see it at the gas pump every time you fillup the family car. When gas prices increased, so too did Inflation.

Now, I'm not saying that this will always be the case. Nor that gasoline alone is responsible for Inflation. Our next bout of Inflation is likely to come from higher food prices.

So we are saying that this economy has a systemic supply issue and that lack of supply drives higher prices. Solve the supply issues, and we'd go much farther in solving the Inflation problem.

Monetary tools such as interest rate management can help reduce some types of Inflation. But not supply-side price hikes.

Just because you have a hammer doesn't mean that everything you see is a nail.