The Fed’s “Jumbo Rate Hike”

What’s it to you …

For the last several months, the Fed has been trying to bring inflation down by raising interest rates. Why might raising interest rates lower inflation? Will it likely work?

The basic idea is that raising interest rates increases the “cost” of money. The Fed can only raise one particular interest rate, which is called the Fed Funds Rate (FFR). The FFR is the overnight lending rate at which banks loan money to each other. Banks are required to maintain a certain level of reserves. At the end of any given day, after a bunch of deposits and withdrawals, some banks may have to borrow from other banks in order to make sure that they are maintaining their reserves. They do so at the FFR.

The current FFR stands at 3%-3.25%. It’s forecasted to rise to 4%-4.25% by the end of the year and peak at 4.5% in 2023. Just for some perspective, the FFR peaked at 20% in 1980 during Paul Volcker’s war on inflation, and Paul Volcker appears to be Jerome Powell’s model chairman.

Getting back to the “cost” of money issue, if banks can borrow money at 3.25% from other banks overnight, why would they lend money for risky things like mortgages at anything close to 3.25%?

They wouldn’t. The current national average for a 30-year mortgage is over double the FFR at 6.7%. It was as low as 2.7% in January 2021.

Housing and transportation are the two biggest spending categories for the American consumer. In the latest report by the Bureau of Labor Statistics, housing was 35% of consumer spending. Transportation was 16%. Together they make up over half of consumer spending. (Used car loan rates, by the way, have topped 10% now for the average consumer.)

This is the basic thesis of the Fed’s interest-rate-hike campaign. Hiking the FFR will force banks to hike interest rates on things like home and car loans. When consumers are forced to pay more interest on loans, they will have less money to spend on other things (like home equity), and prices will stop rising so quickly.

The problem, so far, is that it hasn’t worked exactly as planned. The Fed has raised the FFR from 0.25% to 3.25% in nine months (that’s a twelve-fold increase in the FFR), but inflation is still holding at a 9% annual increase, which is still wildly above the Fed’s 2% target rate:

What exactly is going on here? The economy is what we systems scientists call a “complex system.” (No kidding, right?) The distinguishing feature of a complex system is what we call “nonlinearity.”

For the most part, we experience change in a linear fashion. If a marble is rolling down a smooth slope and we nudge it a little to the left, it goes a little to the left. This is linearity.

In a nonlinear system, however, a small nudge to the left may produce no effect at all, or it may produce a wild swing to the left. We can’t predict what will happen as easily.

Moreover, there are feedback delays. Have you ever steered a boat? It’s not like a car. You turn the steering wheel, and nothing happens right away. Then you turn it more and all of a sudden, the effect kicks in and you’ve way overshot your target.

We are living in nonlinear times, and the Fed is steering a boat through a storm that takes a long time to return a signal to the Fed helmsman. Chairman Powell does his best to project confidence, but the bottom line is he doesn’t know what it’s going to take to bring inflation down to the Fed’s 2% target – and he knows it.

It’s time for us all to know better, too. This game of Fed watching is just that – it’s a game. Yes, we have to play the game, but if we don’t realize that it’s a game, we will most certainly lose the game. If we know it’s a game, and we treat it accordingly, we’ve got a fighting chance of surviving the game.

Survival should be our primary objective in times like these. Jerome Powell doesn’t know what’s going to happen and neither do we. As soon as you forget that indispensable fact and start to buy into a particular narrative about the future of the economy, you’re at a severe disadvantage.

As I said, we have to play the game. If we’re in the markets, we have to place our bets. But our bets need to be smaller right now because the risks are wider in nonlinear times. That’s how you survive.

Fight the noise,
Dr. Richard Smith

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