Interest Rates Highest Since 1994? Inflation and Interest Rates Basics and What This Might Mean for You or Your Company. Part 1

Inflation and Interest Rates Basics and What This Might Mean for You or Your Company.

Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the Federal Reserve and the U.S. central bank, to manage inflation.

 Since 2012, the Federal Reserve has maintained an average annual inflation of 2% as consistent with its mandate to maximize employment and stabalize prices.

Without getting into the nuances and statistics of asset based currencies vs. fiat currencies and their affects on inflation and interest rates, it's worth a quick glance at holding power of an asset like gold.

Inflation simply refers to the tendency for prices to rise in an economy over time, making the money in hand less valuable as it requires more fiat currency to buy the same amount of goods. This reduction in purchasing power is seen as an underlying cause of inflation. While other theories and causes of inflation exist, the idea that changes to the money supply influence price levels has bearing on commodity vs. fiat monies.

It is also important to note that a fiat economy is essentially a debt economy and coexists with inflation and ever increasing national debt. Worth 1,000 pages to discuss this later.

One set back for holding value is that the value of fiat money is based largely on public faith in the issuer. Commodity money's value, on the other hand, is based on the material it was manufactured with, such as gold or silver. Fiat money, therefore, does not have intrinsic value, while commodity money often does. This value is largely created and maintained by borrowing and spending rather than actual value. Changes in public confidence in a government issuing fiat money may be enough to make the fiat currency worthless. There are plenty of examples throughout time.

Let's got back to the inflation concept.

Visualizing Three Types of Inflation

While the price of everyday goods, including food and energy, is the most widely cited type of inflation, other forms exist across the broader economic systems and can affect them differently in scale and intensity. There are 3 core catagories surrounding manageable and measureable inflation.

1. Monetary Inflation

Monetary inflation occurs when the U.S. money supply increases over time. This represents both physical and digital money circulating in the economy including cash, checking accounts, and money market mutual funds.

The U.S. central bank typically influences the money supply by printing money, buying bonds, or changing bank reserve requirements. The central bank controls the money supply in order to boost the economy or tame inflation and keep prices stable.

Between 2020-2021, the money supply increased roughly 25%—a historic record—in response to the COVID-19 crisis. Since then, the Federal Reserve began reducing its bond acquisitons as the economy showed signs of strength.

It’s worth noting that, in theory, increasing the money supply faster than the growth in real output may cause consumer price inflation, especially if the velocity of money (speed at which money exchanges hands) is high. The reason is that there is more money chasing the same number of goods, and this eventually leads to increases in prices.

Looking sideways at the "shortages" of personal care items, bottled water, baby formula etc. I can't help but wonderd how much is strategy and how much is attributed to actual supply issues.

2. Consumer Price Inflation

Consumer price inflation occurs when the prices of goods and services increase. It is typically measured by the Consumer Price Index (CPI), which shows the average price increase of a basket of goods, such as food, clothing, and housing.

Supply chain issues, geopolitical events, monetary supply, and consumer demand may all affect consumer price inflation and tent to happen in fairly predictable trends.

Rising 8.6% in May year-over-year, the CPI hit its highest level in four decades. Undeniably, Russia’s invasion of Ukraine and COVID-19 (whether you believe it or not) have caused extensive disruptions in supply chains, from oil to wheat, leading to increased price pressures worldwide.

When consumer price inflation gets too heated, the central bank may increase interest rates to curtail spending and allow prices to cool down.

3. Asset-Price Inflation

Last but not least, asset-price inflation represents the price increase of stocks, bonds, real estate, and other financial assets over time. While there are a number of ways to show asset-price inflation, I'm going to use household net worth as a percentage of GDP.

Often, a low interest rate climate creates a favorable environment for asset prices. This can be seen over the last decade as low borrowing costs were met with rising asset prices and strong investor confidence. In 2021, household net worth as a percentage of GDP stood at 620%.

Sometimes rising asset prices can be a misleading sign of a strengthening economy since no real output is produced. This is evident since 2019. Instead, this may indicate an asset bubble.

As of 1933, U.S. citizens could no longer exchange currency with the U.S. government for gold. In 1971, the U.S. stopped offering foreign governments gold in exchange for U.S. currency.

Many governments no longer think that commodity money is in the best interests of the public. Mainly, fiat money is not linked to physical reserves, such as a national stockpile of gold or silver. This might be easier to protect and track digitially it does become susceptable to inflation or even becoming worthless in the event of hyperinflation. Look at the Iraqi Dinar.

I digress...

In August 2020, the Federal Reserve adopted average inflation targeting. That framework committed Fed policymakers to hold inflation above 2% for a time to compensate for stretches when the inflation rate fell short of that target. This is problematic for many reasons but let's stick to what this could mean for you or your company.

KEY TAKEAWAYS SO FAR

• Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.
• In the U.S, the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, and the interbank rate on overnight deposits.
• In general, higher interest rates are a policy response to rising inflation.
• Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy.
• The Fed plans to continue raising interest rates in 2022 in order to curb the highest rates of inflation in 40 years.

How the Federal Reserve Measures Inflation

The Federal Reserve's preferred inflation measure is the Personal Consumption Expenditures (PCE) Price Index. Unlike the Consumer Price Index (CPI), which is based on a survey of consumer purchases, the PCE Price Index tracks consumer spending and prices through the business receipts used to calculate the Gross Domestic Product (GDP)

The Fed also closely watches the core PCE Price Index, which excludes food and energy prices that are typically more volatile and tend to be less reflective of the overall price trend as a result.

Here is a quick glance at how these relate to one another.

How Changes in Interest Rates Affect Inflation

When the Federal Reserve responds to elevated inflation risks by raising its benchmark Federal Funds Rate, it effectively increases the level of risk-free reserves in the financial system, limiting the money supply available for purchases of riskier assets.

Conversely, when a central bank reduces its target interest rate it effectively increases the money supply available to purchase risk assets.

By increasing borrowing costs, rising interest rates discourage consumer and business spending, especially on commonly financed big-ticket items like housing and capital equipment. Rising interest rates also tend to weigh on asset prices, reversing the Wealth Effect for individuals and making banks more cautious in lending decisions.

Finally, rising interest rates signal the likelihood that the central bank will continue to tighten monetary policy.

Problems With Using Interest Rates to Control Inflation

Policymakers often respond to changes in economic outlook with a lag, and their policy changes, in turn, take time to affect inflation trends. Hence the personal need to watch these trends and make pivots in your personal life and in your business to ride the waves.

Because of these lags, policymakers have to try to anticipate future inflation trends when deciding on rate levels in the present. Yet the Fed's adherence to its inflation target can only be gauged with backward-looking inflation statistics. These can range widely amid economic shocks that can sometimes prove transitory and other times less so adding to the ever pressing need to understand these fluxuations yourself and learn how to plan for and execute internal growth strategies and external management strategies like supply chain, and capital strategy. Yes, capital strategies should be understood and perceived as both internal and external.

-"In short, if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake," former Federal Reserve chair Ben Bernanke said in 2004 while still a Fed governor.

Central banks trying to anticipate inflation trends risk making a policy error by needlessly stoking inflation with rates that are too low, or stifling growth by raising them.8

In the case of the Federal Reserve, it must pursue its stable prices objective while also trying to maximize employment.

What Next? Getting Ahead of This On a Personal Scale.

Now that you are getting more information to help you make your own decisions, what are the next steps for you or for your company?

Look at trends of companies buying back their own stock, M&A vs. infrastructure spending, alternative assets strategies and project management. As a growth strategy consultant for multiple investment funds, SFO, MFO, and global companies there are a few global shifts happening right now.

We have seen an unprecedented mass exodus from California and other states to more favaorable tax friendly states for individuals and companies alike, but picking up and relocating are tricky, problematic and frankly not the best option for you or your company.

With that being said, let's look at why this might be a long term solution.

Are you or your company in the right place?

Beside packing up and moving what are some other avenues to take? Alternative assets are seeing a lazer focus from high networth individuals and capital strategies for big companies.

The Bottom Line

Interest rates and inflation tend to move in the same direction but with lags, because policymakers require data to estimate future inflation trends, and the interest rates they set take time to fully affect the economy. Higher rates may be needed to bring rising inflation under control, while slowing economic growth often lowers the inflation rate and may prompt rate cuts.

Being able to see these trends, understand their drivers, and know the potential windfalls or opportunites is crucial for any individual or company. You can effectively plan for and benefit from each of these. Just know that there will always be these delays and that gives you the time to have a plan in place, and pivot as needed.

Nothing is guaranteed, but if you can see the signs and through a little introspection, you can prepare for these times. We are living in a massive shift, but there is plenty of time to ride the wave to shore.

Leaving you hanging for part 2, kindly,

Ben