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Interest Rates, Inflation, and the Federal Reserve

September 14, 2020

First, the History

The central banks of the world began as a tool for political leaders in a given country to support the goals and aspirations of whoever was in charge at the time. Therefore, they generally primarily focused on economic growth. Typically, inflation threats were ignored until they became so serious it started to affect the overall economy and business community.

After a series of disastrous inflation spikes that seriously impacted multiple governments, it was determined that central banks needed to be independent of politics in order to follow the ebbs and flows of the economy rather than the desires of politicians. The U.S. Federal Reserve is such an independent body with a Board of Governors that are nominated by the President and approved by the Senate. Their terms do not match the terms of the President or Senators and the decision-making process is consensus based. The body that makes the important decisions regarding the Federal Funds Rate is the Open Market Committee, which is composed of the members of the Board plus four regional Fed Presidents that rotate in for one-year terms. The role of regional President is selected by a local board. The point is to demonstrate that the Fed is truly designed to be independent.

Central Banks’ Objectives

The central banks were formed with dual mandates – maintain a lid on inflation and promote job growth. These can often be mutually exclusive goals. Growth often drives inflation. If the decision is made to get inflation under control, the impact on growth will be swift. The primary tool used to adjust between these two goals has been the Federal Funds Rate. Raising interest rates will clamp down on inflation while lowering them will result in growth. At least by design. Unfortunately, this system has not worked as it should for the better part of a decade and the Fed (as well as most of the other central banks) are now engaged in a radical rethink.

Three Fundamental Questions

There are at least three fundamental questions to be addressed. The first is whether there is going to be a future threat from inflation sufficient for the Fed’s concern. The second is whether the Fed could do anything about that if it wanted to. The third is whether the Fed has the tools needed to stimulate the economy.

  1. There are many factors that drive inflation. The three that are at the top of the list have been wage inflation, commodity inflation, and the inflation of the money supply. None of these are manifesting as expected. Just a few months ago the unemployment rate stood at a record low of 3.5% and yet there was no wage inflation. The Phillips Curve demonstrates that there should be, but it was nowhere to be seen. Now the unemployment rate is over 10% and that certainly mitigates against higher wages. There has been no surge in commodity prices either – even when demand was strong. Oil prices stayed down and hit record lows. Metal prices and farm prices have remained low despite some temporary spikes.

    As a rule, adding trillions of dollars to the economy would create the inflation that comes with an expanded money supply, but that isn’t the current situation. What has been accounting for this? The primary issue is lack of demand. The latest surge of spending by governments trying to stimulate the economy has coincided with a lockdown recession. The decisions to close certain businesses and restrict others has meant that people have fewer options available as far as spending is concerned. Even before this crisis there was reduced demand due to simple demographics. The Baby Boomer has traditionally been a spending machine and they’ve reached the point in their lives when spending slows. The Millennial and the Gen-Z consumer have not picked up the slack. The Fed has put a lot of money in the hands of banks, but they are not lending aggressively due to the weak economy, reduced demand, and fewer qualified borrowers. The bottom line is that inflation has simply not emerged, nor is it likely to any time soon. 
  1. This leads to the decision by the Fed to declare their intent to leave interest rates very low for an extended period of time. There has been an expectation that rates will go up when the rate of core inflation reaches 2.0% to 2.5%, but the Fed has indicated they will not automatically move interest rates up when it hits that level. A replacement goal has not been suggested so the level that triggers a response becomes anybody’s guess.

    At this point there is nothing on the horizon that would indicate a rise in inflation. None of the triggers are active and until there is full recovery from the pandemic inspired recession there is little to move them. The Fed has all but stated that rates will remain where they are for the next year or more. That can always change but this is the pattern for now.
  1. A bigger question is whether the Fed or any other body can do much to spur growth. Ordinarily, lowering rates would trigger lending and borrowing, but rates have been down for years and that has not occurred to the extent expected. The fiscal side has dumped money in the economy through a variety of spending efforts and reduced taxes and there has been tepid response. Perhaps the most accurate description of the current consumer is tired. And adding to that, most markets are saturated (there are almost two cars for every household in the U.S.).

    Consistently low rates will have long term implications for investors as well. Bond yields will remain low and that will mean continued low mortgage rates. The dollar will weaken to a degree but since every other nation has low rates the dollar is not all that adversely affected. Returns on investment will be reduced and that pushes investors away from bonds and towards riskier equity markets and commodity markets.

Normally, strategies are put into place to take account of both high and low inflation periods and therefore high and low interest rates. However, for the immediate future there is little need for this due to the minute chance of rising interest rates or rising inflation. The implications are particularly interesting for the insurance industry. With expected interest rates to remain low, what options does that leave insurance companies? Do they chase yield with higher credit risk or stay the course with floating rate securities hoping rates rebound?