We liken real interest rates to a speed bump. Too high and traffic is stopped: innovation, long-horizon investment in new initiatives, entrepreneurial capitalism all slow markedly. Too low and reckless driving ensues: if we are among those able to borrow at negative real rates, we will, whether we have good ideas for the money or not. Misallocation of resources and malinvestment—at the individual, corporate, and government level—naturally will follow, along with propping up zombie companies that clog the runway for the innovators. All of this in turn inhibits innovation and entrepreneurial capitalism, both because risky projects cannot access those ultra-low rates, and established enterprises and government may waste much of the free money at their disposal.
Being late to the game increases the probability that the Fed overreacts, because it didn't act soon enough. This increases uncertainty and elevates the probability of a hard landing, which is what everybody wants to avoid. Hard landing means we go into a serious recession, like the one associated with the global financial crisis. There are huge economic as well as human costs associated with hard landings. Nobody wants to be laid off or to spend an extended amount of time on unemployment insurance. A soft-landing scenario is much more desirable. That could mean slower economic growth or maybe a mild recession before the economy moves into a recovery phase.
The main issue is that the Fed ignored inflation for far too long. One of the main things we worry about is that the Fed board members believe that increasing interest rates is sufficient to fine tune inflation. If they really believe that, it's dangerous. Outsiders are not privy to what happens at the FOMC other than reading the summary minutes, because the detailed minutes are only released after five years. Traditionally, interest rate hikes have been the go-to tool in a tightening regime and have had some historical success. But this time might be different. Indeed, every time is different.
What are the root causes of the inflation we have now? Some of them are intuitive, such as supply chain disruptions. Will the Fed’s raising interest rates by 75 basis points make a difference to supply chain disruptions? No. To deal with inflation, we need to deal with the source of the problem and address it directly, not just hit it with a blunt instrument that sometimes worked in the past. The usual approach does not inspire confidence. We worry the Fed is going to mess it up.
Step number one is to go through the individual components driving the 8.6% CPI inflation number. Consider housing, for example. Given that a homebuyer can get a mortgage for much less than 8.6% means that effectively the financing is free or being subsidized. In terms of real rates, this increases the demand for housing. So, for this component, raising rates appears to have some logic. That is the sort of analysis we need to see. But the housing issue is much more complex, encompassing not just the demand for mortgages, but the demand for materials, and the structural backlog caused because we have not been building enough housing over the last five years. The rise in housing prices has nothing to do with Covid.
The near-term prognosis for inflation is not good. Each month’s 12-month inflation rate matches the previous month’s inflation rate, plus a new month, minus the corresponding month dropped from the previous year. We can’t know with any confidence what the new month’s rate will be, but we know with precision the rate of the month being dropped. The next four months to be dropped from 2021 will be 0.9%, 0.5%, 0.2%, and 0.3%, respectively. The Cleveland Fed produces an “inflation nowcast” which estimates what the monthly inflation would be if the month ended today. If their nowcast is correct, the 0.9% from June 2021 will be replaced with 1.0% for June 2022. If inflation in each subsequent month through year-end 2022 matches the average inflation rate over the prior 12 months, we should finish the summer at 9.9% and finish the year at 10.8%. If, alternatively, monthly inflation recedes to match the trailing 36-month average, then the current 8.6% inflation rate would remain steady through year-end. This simple analysis leads us to believe that inflation will likely get worse before it gets better.