In today’s Exponential Investor:
- A quest to undo market myths
- Rate hikes won’t reduce inflation
- Money follows the path of least resistance
Today, I continue in my quest to undo market myths and what I consider to be persistent untruths.
You see, I’m kind of over those simplistic views on how inflation is all the fault of the central banks.
Don’t get me wrong, I’d love to blame them. Lay the cost-of-living crisis at their feet and stomp away, vindicated that it was us versus them all along…
The thing is, it’s just not true.
We live in a complex global economy and the central banks’ actions are only a small part of why our grocery and energy bills are through the roof.
Yes, we can blame central banks for the misallocation of money, which led to bubbles in stock and property markets.
But it’s time to admit they aren’t to blame for everything.
In fact, people like you and I are partly responsible…
Rate hikes won’t reduce inflation
The mothership of all central banks, the US Federal Reserve (the Fed), has been the most aggressive central bank to attempt to control inflation.
After dropping rates to a whisker above zero in March 2020, the Fed has been leading the way for major central banks by raising rates since March this year. In six months, it has lifted the Fed funds rate from close to zero to 2.5% today.
Federal Reserve leads interest rate hikes
Source: Trading View
Fed is blue; Bank of England is orange; European Central Bank is aqua; Bank of Japan is yellow
Speaking from Jackson Hole – at the annual US central banking summit to discuss monetary and macroeconomic policy – Fed chair Jerome Powell said:
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.
“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Until last week, there was the expectation that the Fed would pivot by early next year and start reducing rates. These comments have now led the broader market to believe the Fed will continue to increase rates well into 2023.
Closer to home, however, the Bank of England is finally catching up to the rate-rise race after predicting UK inflation will reach a crippling 13% two months from now.
Traders are now betting the BoE’s rate hikes will peak at 4% in 2023, similar to where the Fed will land.
With UK’s cash rate now at 1.75%, we can expect several – and large – increases at coming policy meetings.
The problem is, these rate hikes aren’t going to fix the very thing we’re being told they are hoping to fix.
Money follows the path of least resistance
As inflation whips through at dangerously high levels, criticism is being levelled at central banks for lifting rates and causing a recession.
Frankly, raising rates is the most responsible thing central bankers could do right now. Yet too many analysts continue to demonise them for engineering a hard landing.
We are already living in a time of experimental monetary policy, and the use of low rates to respond to an economic emergency had long outstayed its welcome. Normalising interest rates should have happened much sooner than it did.
Do central banks need to admit to their loose monetary policy mistakes and attempt to fix them? Absolutely.
They kept the cost of money too cheap for too long, causing asset bubbles to build in houses and stock markets.
A difficult pill for all of us to swallow is that markets are tanking because of the misallocation of investment precisely because of central-bank intervention.
Money follows the path of least resistance. With interest rates of next to nothing, the “easy” way to make a profit was to invest in stocks instead of putting cash in the bank to earn next to nothing from interest rates.
Nonetheless, we can’t be foolish and think that a fast tightening cycle is going to reduce inflation.
One of the major contributors to high inflation in the UK is energy costs (the other being food prices). Sky News recently wrote that, after polling Liberal Democrats, up to 23% of them will not be turning their heat on this winter.
And who can blame them? The Financial Times said power bills across the UK will increase by 80% in the next 12 months.
These kinds of energy price rises will bring hundreds of thousands of people dangerously close to the poverty line, increasing the likelihood that the British government will have to give people handouts to combat debilitating power bills.
The thing is, no amount of rate rises from the BoE will reduce the price of gas, coal or oil. The longer Russia marches across the Ukraine, the longer high energy costs will endure.
Rapid rate hikes will deter certain investments and consumption, but absolutely will not bring the annual inflation rate to pandemic levels.
Jacking up rates doesn’t end inflation. It will deter consumption in a service-based economy such as the UK, in turn creating a much bigger problem in the long run. Growth in the UK economy relies on people consuming goods and services. If consumption falls, the coming recession could be much deeper than predicted.
Dare I say it, but today’s inflation problem is rooted in the investment decisions made two decades ago… and the worst is still to come.
More next week.
Until next time,
Co-editor, Exponential Investor