*Originally published August 18, 2023
By Tim Courtney, Chief Investment Officer
June’s inflation reading showed signs of additional cooling, coming in at 3%1, but the Federal Reserve has kept on course and increased interest rates to their highest level in 22 years.2 The Fed is doing this because 3% inflation is still above their target and is on top of the 15% inflation we experienced from June 2020 to June 2022. However, the inflation report prompted a positive response from the market.3 The market is hopeful that as inflation gets under control, the Fed will change course and begin cutting rates.
Policymakers have joined many investors and consumers in advocating for lower rates. However, we believe it is important to keep a few factors in mind before clamoring for lower rates.
1. Vested interests. Maybe lower rates are the right policy for the next few years. That is certainly possible and probable if we go into recession. However, most parties making the case for lower rates aren’t doing so because they think we are headed for recession. Consumers want lower car payments. Investors, specifically speculative investors that utilize high levels of leverage or focus on companies with low current profitability, want their borrowing costs to fall and their asset prices marked up as rates decline.4 Governments in the U.S. and around the world cheer for easier financing to cut borrowing costs and enable more spending, as Fitch Ratings was recently reminded.5 None of these parties (save Fitch) want to enact the kind of discipline necessary to comply with higher rates.
2. Low rates started the mayhem. When interest rates were slashed to zero in 2020, it ushered in an era of speculation and spending we have never experienced. Money and borrowing were cheap, and dollars were being badly misallocated as they flowed anywhere and everywhere (e.g., unprofitable startups, SPACs, crypto, NFTs, etc.).6 These misallocations heavily impacted the economy and labor markets, and we are still unwinding the distortions and inflation they caused.
3. Savers and investors need to be properly compensated. Disciplined savers and investors need an expected return that properly compensates them for the risk they take. Cash and bond investors weren’t properly compensated in the years following the Great Financial Crisis in 2008. From 2009 – 2022, inflation ran at 2.5%, but most cash, CDs, and government bonds didn’t provide nearly enough return to match inflation or pay taxes on the interest.7
As the referees of our financial system, the Fed and other central banks must work towards keeping interest rates at a natural, functional level that manages inflation, among other things. If that means higher rates so that consumers, capital allocators and the government must make more disciplined choices, then all the better. As savers and investors, we should then be more properly compensated. If you have questions, don’t hesitate to contact your Exencial advisor.
- CNN Business (7/12/23) — US inflation cooled in June for the 12th straight month
- NBC News (7/26/23) — Federal Reserve raises key interest rate to highest level in more than 20 years
- CNBC.com (7/28/23) — Dow rises 200 points Friday after tame inflation data, heads for 3rd winning week: Live updates
- Bankrate (5/19/22) — What is speculation and how does it affect your investments?
- BBC News (8/2/23) — Fitch downgrades US credit rating from AAA to AA+
- Decrypt (12/23/21) — The biggest crypto story of 2021: NFT boom
- DFA Returns 2.0/Bankrate (07/31/23) — US CPI, One Month T-Bills, One Year CD, Five Year US Treasuries, Bloomberg US Aggregate Bond Index all returned less than inflation between 2009 - 2022
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