On the heels of the first interest rate increase since 2006 we came an article from BloombergBusiness that should be of interest to everyone. The article highlighted a “bizarre” theory that is quite logical and fits in well with our own long held beliefs. That theory, touted by “Neo-Fisherians”, proposes that increasing interest rates might be what is needed to push inflation higher, as opposed to the established policy of lowering interest rates, a longstanding position of the Federal Reserve during times of crisis.
The article contained the following thoughts:
“Many economists are so perplexed by the lack of inflation in the U.S. after years of unprecedented monetary stimulus that a bizarre, century-old theory is suddenly gaining traction: Maybe higher interest rates are what’s needed to push up consumer prices. The idea runs counter, of course, to basically everything taught in Economics 101 classes (higher rates, we’re told, discourage rather than encourage spending and therefore curb inflation).”
This idea of “running counter to basically everything taught in Economics 101” almost explains why it may be useful and necessary for application to the current economic environment. For the most part, Economics 101 is primarily a set of theories that apply only if all other variables remain unchanged, which is usually never the case. It should be noted that this potential shift in policy couldn’t become an idea in the mainstream thinking until all other possibilities have been exhausted.
The article promotes the idea that the Federal Reserve somehow is on the leading edge of setting policy. We don’t believe this to be the case. In our November 2015 article on gold and interest rates, we said that market rate movements take place before the Federal Reserve takes action, rather than the other way around.
In a comparable interest rate cycle, from 1948 to 1981, we can see that the discount rate followed each rise in the short-term rate. Likewise, the most recent rate increase has followed a low and subsequent increase in the 3-month Treasury and the 10-year Treasury, as seen below.
Another challenge is with the article’s claim that “…higher rates will make people think the economy is doing better and, as a result, they’ll start spending more. In other words, project strength and strength (as well as a little inflation) will follow.” This line of reasoning doesn’t fit with the reality of what happens.
Short-term rate start to rise reflecting the view that the economy has improved which is followed by similar action by the Federal Reserve. Rising rates reflect a growing sense, and reality, of increased inflation which consumers attempt to stay ahead of by spending more current dollars. The spending of current dollars initially is about confidence in the economy. However, the long-term impact in a rising inflation and interest rate environment, is that it quickly becomes about spending current dollars to beating inflation.
A single rate increase by the Federal Reserve in no way makes for a trend. However, markets often lead the way and what initially seems “bizarre” is only a natural change in regime, a change that we haven’t seen since the early 1940’s.
