How does the Fed reduce inflation? Interest rate cut!

Why is U.S. inflation still higher than the central bank\’s target after the Federal Reserve implemented the most aggressive rate hike in generations? What is the reason why the rate hike did not work as expected? In this regard, a senior figure in the U.S. bond market asked A view that goes against orthodox theory: The Federal Reserve needs to cut interest rates to further reduce inflation as expected.
The Fed has to lower interest rates to lower inflation. Normally, when inflation becomes a problem in the economy, the Fed raises interest rates to combat inflation. This actually increases borrowing costs for U.S. businesses and consumers to curb demand.
Its goal is to stabilize prices by encouraging more saving and less spending, thus slowing economic activity.
This orthodox monetary policy usually works well.
Controversially, over the past few years, we have all witnessed Fed Chairman Powell\’s success in fighting inflation.
Between March 2022 and July 2023, Powell will raise the federal funds rate from near zero to a range of 5.25% to 5.5%.
Subsequently, rising borrowing costs across the U.S. have helped rein in a once-surging housing market, a major source of inflation; leading to at least mild deflation in the stock market in 2022; and limiting consumer inflation expectations, which may evolve a self-fulfilling prophecy).
Subsequently, the inflation rate dropped from a 40-year high of more than 9% in June 2022 to 3% in July of the following year.
The U.S. monthly CPI annual rate, however, has since been hovering between 3% and 3.5% despite high interest rates continuing to weigh on the U.S. economy. Inflation has failed to fall to the Fed\’s 2% target.
Some economists believe the slowdown is the result of Powell\’s decision to keep interest rates steady for nearly a year rather than implement more rate hikes.
But Rick Rieder, BlackRock\’s chief investment officer for global fixed income and head of its global allocation team, has a different theory. One that seems to go against orthodox economic theory.
In an interview, Rieder believed that the Fed\’s interest rate hike was not a good medicine for the current disease of the U.S. economy.
He said: It\’s unclear to me at this point whether higher (interest rates) will help reduce inflation or actually fuel inflation.
The 14-year BlackRock veteran believes the Fed may need to change strategy and choose to cut interest rates to combat the remnants of inflation.
He manages $2.4 trillion in assets at BlackRock and is one of the leading voices in the bond market.
That’s all because many low-debt, cash-rich consumers and businesses — especially baby boomers and Fortune 500 companies — are actually profiting from higher interest rates, Rieder noted.
Rieder explained that the savings boom driven by U.S. government spending and asset price appreciation in the COVID-19 era have made these big businesses and wealthy consumers net lenders, not borrowers.
Now. With higher interest rates providing strong returns for anyone with cash to lend, the private sector\’s lending position creates a steady stream of inflationary income in a key area of ​​the economy.
Rieder added: \”If you think about what has happened over the past few years, there has been a huge shift from the public sector to the private sector.
Companies pay off their debt. Individuals deleverage. You have a dynamic. You have a lot of savings and money in money market funds.
Now. If you look at service level inflation. Part of the reason is that these companies and individuals have so much revenue flowing through the system. It actually gets recycled.
Not so long ago, Rieder\’s hypothesis that higher interest rates might benefit a specific segment of the population, thereby exacerbating inflation, was considered unconventional, at least on Wall Street.
But now, according to the minutes of the May 1 Federal Open Market Committee (FOMC) meeting, even Fed officials are beginning to consider the possibility that the impact of higher interest rates may be smaller than in the past.
Here\’s why some of Wall Street\’s top names and the Fed\’s best economists are changing their minds about the impact of higher interest rates on the U.S. economy: Reason 1: Baby boomers bring about a consumer boom The so-called baby boomers. refers to the 1946 World War II The number of Americans born between the end of the year and 1964 was as high as 76 million, accounting for one-third of the U.S. population at that time.
As the generation with the largest number of births in the history of the United States, the baby boomers have been the mainstay of the U.S. economy in recent decades. They have also accumulated extremely considerable wealth. Most of them are currently between the ages of 59 and 77. They have retired or are close to retirement. age.
Rieder pointed to the staggering wealth and consumer appetite of older Americans as one of the reasons why the Fed has struggled to control the key services component of inflation.
This is boosted by their new role as lenders in a rising interest rate environment.
Services inflation — especially inflation in core service industries excluding housing, which includes prices such as medical care, entertainment, tuition and insurance, but not housing or energy — has been one of the Fed\’s top areas of concern for years.
As early as November 2022, Powell said that this indicator may be the most important category for understanding the future evolution of inflation.
There are several reasons for this prospect.
First of all, the service industry accounts for more than 70% of the U.S. economy.
Secondly, inflation indicators in the core service industry excluding housing factors are often used to measure so-called cost-push inflation. This kind of inflation is driven by wage or wealth growth. It is used to observe whether price increases have become entrenched in the economy.
Now Rieder believes that many wealthy, often older Americans tend to spend more money on services, and they may be inadvertently preventing disinflation in this key sector of the economy.
He said: People over 55 are now big spenders – which is actually quite remarkable.
Especially middle- and high-income people (elderly people) now have a lot of savings.
This will flow directly back into consumption, including highly sticky areas such as entertainment, leisure and medical care.
To Rieder\’s point, the Bureau of Labor Statistics\’ Consumer Expenditure Survey shows that older Americans tend to spend more money on entertainment, medical and other service categories, and the Fed is trying to fight inflation in these areas.
In 2022, Baby Boomers will spend an average of $3,476 on entertainment. Gen Z will spend about half that. Just $1,693.
Likewise. Baby boomers will spend an average of $7,116 on health care in 2022. Millennials will spend $4,156. Gen Z will spend just $1,560.
\”In these areas, what you\’re seeing is service level inflation, so it\’s very difficult to bring it down,\” Rieder said.
Older Americans are also in a good position in terms of wealth and debt. They can continue to spend in these key service industries that can drive up inflation.
Federal Reserve Survey of Consumer Finances. Americans collectively held $147 trillion in assets at the end of 2023. But about half of that wealth — $76 trillion — belonged to the baby boomer generation. The silent generation held another $20 trillion.
As Ed Yardeni, senior economist and market strategist who runs Yardeni Research, said in a recent report: They are the wealthiest group of seniors ever.
Not only are older Americans rich in assets, they also have much less debt than other generations. This means that as interest rates rise, these new and well-known private lenders have a steady stream of spending money.
Census data shows that by 2023, baby boomers will have only $1.1 trillion in consumer debt, while Gen Xers and Millennials will have $3.8 trillion in consumer debt, despite owning far more assets.
Likewise, baby boomers will hold $2.7 trillion in home mortgage loans by 2023, compared to $9.9 trillion for millennials and Gen Xers.
A Redfin survey shows that about 54% of baby boomer homeowners also own their homes outright, compared to about 40% of the general population.
Yardeni noted that many older Americans also have the opportunity to refinance their mortgages at record-low interest rates in 2020 and 2021.
The bottom line is. Most baby boomers have now finished paying for their children\’s college; many have just received an increase in their Social Security payments; and some are finally getting a real return on their savings. Let them have enough Money can be spent.
Rieder believes that all of this is good for older and wealthy Americans, but it could become a problem with service-sector inflation.
When it comes to the impact of high interest rates on the wealthy, it appears that at least some Fed officials agree with Rieder.
At the May 1 meeting of the Federal Open Market Committee, multiple participants noted that first-quarter financial conditions appeared to be favorable to wealthy households.
Reason No. 2: Cash-rich companies are profiting from higher interest rates It\’s not just the wealthy who are changing the way interest rates affect the U.S. economy. It\’s often also America\’s largest corporations.
There is evidence that some of the largest U.S. companies will be able to pay down their debt before the Fed raises interest rates or locks in debt at low interest rates for the long term.
Now, for the first time in more than a decade, these companies are making handsome returns by doling out extra cash as interest rates rise.
To Rieder, all this means is that it\’s unclear whether higher interest rates actually create more inflation.
Rieder isn\’t the only one making this argument, either.
August 2023. Societans strategist Albert Edwards, known for bemoaning the rise in greedy inflation during the COVID-19 pandemic, wrote a report describing what he called the craziest macro chart in history.
The chart below shows that despite rising interest rates, U.S. corporate net interest payments will fall sharply in 2022 and 2023.
According to orthodox economic theory, higher interest rates should increase borrowing costs. So what happened? It turns out, as Rieder describes it, that many companies were able to reduce their debt loads or lock in low debt before the Fed raised interest rates to combat inflation. interest rate debt.
(The Fed\’s now-infamous temporary call to delay long-anticipated rate hikes in 2021 gave many companies time to prepare for a higher rate regime.
)Meanwhile, after interest rates rose, many of these companies became lenders.
The end result, Edwards said, is that large companies become net beneficiaries of high interest rates.
Edwards wrote in an August 2023 report: Higher interest rates added 5% to profits last year, rather than dragging down profits by more than 10% as usual.
Interest rates simply aren\’t as efficient as they once were.
Edwards believes that stable rising interest rates have provided revenue for large companies, helping the United States avoid a recession by improving corporate profit margins and strengthening the labor market last year.
But now, Rieder warns, the trend may also intensify the uphill battle against the remnants of U.S. inflation.
After all. Creditors have done pretty well. The private sector has now become the creditor.
The investment of baby boomers with abundant funds in these large companies has also reaped returns. The best way is the U.S. stock market, which has hit record highs.
Cut or not, Rieder still sees an opportunity for fixed-income markets to take into account Rieder\’s views on how higher rates affect inflation. No wonder he believes the Fed will cut rates this year.
But even if the Fed disagrees with his view on the economic impact of higher rates, Rieder still thinks there\’s enough evidence to suggest they should cut rates.
There has been some mild softening in employment and consumer spending. Inflation, although still high, has remained steady.
Rieder said: I just think the Fed wants to see a window where inflation is not accelerating.
If you have a few months of data. You should have enough data for them to start cutting rates.
Rieder said he expects a rate cut by September.
The timing is certainly favorable for the BlackRock Flexible Income ETF (BINC), his first actively managed ETF, launching in July 2023.
BINC is a diversified bond and income ETF designed to provide clients with lower volatility high-yield bonds.
This ETF seems to have been launched with timing in mind.
Bond prices tend to rise as yields fall. That means lower rates will support Rieder\’s holdings—marketing materials in March 2023 even mentioned a possible end to the Fed\’s rate hike cycle. That creates more for fixed income Chance.
But Rieder said that even if the Fed doesn\’t cut interest rates immediately, he believes bonds now offer an attractive opportunity for investors looking for stable income.
He said: There are benefits everywhere.
So you can continue to hold higher quality (bonds) than you have in the past.
With inflation remaining high and forcing the Federal Reserve to keep interest rates higher, Rieder sees the current market as a golden opportunity for bond investors to lock in higher yields. If interest rates do fall, they may be able to profit from some capital appreciation. .
Rieder said: For me, this is an incredible gift.
As inflation remains at current levels, it costs us less to purchase credit assets than it should.