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Inflation and Rates - Why rates may not go down anytime soon.

Inflation and Rates - Why rates may not go down anytime soon.

August 11, 2023

Inflation's Recent History

Right now, I'm listening to CNBC talking about inflation dropping faster than the Fed expected and will stop raising rates soon. However, IF inflation keeps tracking with with the period of 1966 - 1982, we may be in for more.
History doesn't always repeat itself, but it often rhymes..
This is the Federal Reserve Banks biggest concern - a second spike in inflation. As you can see from the chart, this is how things played out in the beginning of the 80's, and then Fed Chair Paul Volker raised the Fed Funds rate until inflation was under control. While you can argue about the economic effects of government spending, the fact is inflation was quite low and under control until the government spending spree started.

The Fed and Interest Rates

As I've mentioned before, the Federal Reserves primary method of achieving their mandate - full employment and inflation at 2% - has been to raise or lower the Fed Funds rate to either stimulate or slow the economy.  Currently at 5.25% - 5.50%, this is a target rate at which commercial banks borrow and lend their excess reserves to each other overnight.

However, if the larger banks have adequate reserves (and they do), and they're not borrowing overnight, does this rate really mean as much as people think. I'm not sure, and I think you can make the case that this is why we haven't yet entered a recession.

We've Never Been Here Before

If history does repeat and we experience a spike in inflation forcing the Fed's hand, the "overnight" rate will likely remain elevated, even if we enter a recession. But, this time may be different for two additional reasons - 1) $8 trillion of Treasuries and Mortgage backed securities on the Federal Reserves balance sheet, AND 2) our incredible amount of national debt at $31 trillion!

We've never been here before, and how this plays out, who knows.

What is Really Driving Rates

In 2008 the Federal Reserve employed a new way of controlling rates - Quantitative Easing (QE).  At that time, coming out of the housing crisis, they needed a way to control long term rates and recapitalize the banking system so they began printing money and purchasing Treasuries and Mortgage backed securities and parking them at the Fed. From 2008 - 2022, these purchases amounted to $9 trillion.

The U.S. bond market is approximately $30 trillion, and if you recall Econ 101, when you have less supply, prices rise.  AND, when bond prices rise, interest rates go down.  So, by taking these bonds/securities out of the market, the Fed lowered supply, which raised bond prices, which lowered interest rates and let the housing market heal.

Increasing Supply

Starting in September of 2022, the Fed reversed course and entered into Quantitative Tightening (or QT).  In QT, the Fed not only stopped buying treasuries and mortgage back securities, but they stopped replacing them as they matured allowing them to "roll off" their balance sheet.  In turn, this has increased supply, and long term rates have increased significantly causing the economy to slow.

But they're just getting started and they're is still a massive amount of supply that will likely come to the Bond Market in the next decade!  If this happens, rates will NOT come back down, in fact they will likely go higher.

Michael P Henderson, CFP® CKA®

Founder - Crossover Point Advisors