Can Rising Interest Rates Stop Inflation?

When it comes to the markets, things have been a bit all over the place … so much so trying to make sense of things is frankly maddening. But its safe to say that the topics that have been dominating have been Inflation and the federal reserve … and its commitment to fighting inflation.

But investors and traders themselves are doing their bit … seemingly on a day to day basis. You don’t have to look through too much history (re: the S&P 500 index) just in the last few months to see whiplashing movements in both directions, where each downward movement is followed by some article about ‘Worries of inflation pushes markets lower …’, each upward movement followed by trailing headlines, ‘Worries of inflation easing …’

Seemingly at random, indexes drop a few percent here and there, respond in equal measure days later, reverse for no reason with no warning (with no changes to fundamentals) … because inflation is … bad! But nothing highlights the emotions of the markets than when the CPI figures get published, and in the following days, the markets start to ‘trend’ upward. The S&P500 held steady for 6 days before falling after the CPI print on the 12th of April.

The index swung from pillar to post after the report on the 11th of May, prior to rallying toward the end of the month, and after reporting record and accelerating inflation on the 13th of July, the market has rallied! So what caused the previous selloffs? Were people afraid of inflation going down? (sarcasm)

Seriously …. WTF is going on? Who knows. Markets are driven by people, and people are irrational. When you take two forces such as Supply and demand, and then toss in a hefty dash of Fear and Greed, and things seem to do whatever they like, even when things are counter-intuitive.

But this isn’t about what the markets are or aren’t doing!

Can Rising interest rates stop inflation?

Lets try to unpack it 1,600 words or less – if you’re a glutton for unfiltered thought, check out the monologue above!

What caused inflation to spiral?

First and foremost this is not a single variable answer. Covid didn’t help for one thing, Supply chains got out of balance, government stimulus packages went from Billions to Trillions (think about that), and with a stack of questionable policy decisions, mirrored by leaders around the world … throw in a war that everyone but the politicians saw coming, sanctions that have cut both ways and things began to set themselves up for a bit of a perfect storm.

By the time supply chains started to dry up, and money started to flood into the economy; the stage seemed to have been set. What we do know is that everyone and every sector in some way was effected. But perhaps what we have seen is that two sectors have had (in my opinion) larger impacts than others. And these have been the Semiconductor industry and the energy sector.

Related: How low interest rates impact your future

To the front of the class you two …

The mantra is often, ‘Too much money chasing too few goods’ is what drives inflation, and its not untrue. Fundamentally its down to supply and demand, the two most fundamental, non-emotional forces in any market. If supply is disrupted in any manner, whilst demand remains constant, then the cost of whatever is supplied is open to higher price … and this can simply be set by anyone. Lots of things drive price, urgency from the consumer side is one thing, price setting from the supply side is another.

When the semiconductor industry got as unbalanced as it did, I for one was forced to take a shallow look at how an industry could be …. So, rattled. Here’s the thing, semiconductors (chips) aren’t the types of things that can be produced in a day. They have fine architecture, microns and in mobile and computing systems the architecture is down to Nanometres … not the type of thing you can just drill or mill … these are types of structures that literally need to be grown!

Yes! Grown! With 0 defects, in pristine foundries, where single specs of dust can ruin entire batches of chips. The same marvels of engineering that give us the ability to stream 4K videos on our phones, at absurd throughputs, are the same chips that take over 1,000-2,000 manufacturing steps over the course of 6 months just to complete a single batch of chips. When the automotive sector put the brakes on manufacturing and the world started working from home, the chip manufacturers weren’t prepared … hell no one was. The sudden shift in demand was felt immediately. Even now lead times for computers are in the range of 6-9 months for industry and demands aren’t exactly slowing down, and semi-conductors are playing catch up. Current speculation suggests, shortages won’t be addresses perhaps until 2024!

In a world, where everything has a chip … stock of product dries up, price go up!

What about energy? War is one thing. Bad policy is another. Energy ignorance is plain criminal negligence. Quite frankly it doesn’t matter what the most powerful reason actually is, global policy to wage war on fossil fuels, pushing for renewables in unachievable time frames, cancelation of pipelines, wars, sanctions on crude supply (that still gets purchased by bargain hunting countries) … the cost of oil and natural gas has risen.

Its happening to the point where electricity providers in Australia, are actually contacting customers to tell them, ‘prices are rising … shop around’, but the majority of us are feeling it at the pump! In Melbourne, Petrol (Gas) got to $2.4/ltr ($13.65USD/gal).

Just writing that number is infuriating! But stripping all of the politics and hypocrisy from the picture, Energy is used … everywhere. You want to travel beyond walking or ‘cycling’ distance … you’re using fossil fuels. Electric car? Your electricity is likely come from fossil fuels! Your food? Transported by a truck using diesel; Grown with the help of a tractor using … diesel. Every kilometre travelled from input, to final delivery is more expensive. Those prices get passed onto … the consumer!

When it comes to energy … Australia is doing quite well … in the middle of the day, but everything in Tan, Orange or Green might not be there when its needed.

Related: Its time to talk about energy.

 So why are interest Rates going up?

Markets are one thing, but the economy is another. Inflation is also one of those nasty things that has a potential tendency to feed on itself, and to simply grow and grow. Over simplifying things as happens on this website, pricing, and value need to be kept under control … within control.

When inflation is too high, the value of money depreciates too quickly, and consumers rush to spend … fuelling inflation. When the value of money appreciates such as a deflationary situation, people will naturally want to hang onto their cash because it will be worth more, albeit at the expense of businesses needing to keep money circulating.

It’s a high wire tight rope walk. You gotta keep the economy in a goldilocks zone, not to hot … not to cold! And right now, its pretty hot. I would go as far as to say, ‘don’t let falling market values and charts fool you.’

The federal banks, the federal reserve, reserve bank Australia, European central bank … will typically have two tools up their sleeve to regulate the economy, interest rates and quantitative easing or tightening.

After having bought so many billions in government bonds, the US economy is flush with cash, and prices are rising, that money is losing value … interest rates need to go up. There needs to be a rebalance in supply or a reduction in demand.

What we do know is that things haven’t gone according to plan for the fed! It wouldn’t take long to find comments in 2021, that rates wouldn’t start to rise until 2023 … or … earlier in the year, that 75 points were off the table … that lasted about a month! Who knows … we could see 100 points soon.

The fed is slamming the brakes on, and the discs are starting to glow! The economy is a heavy beast, and things take time to happen.

Related: Quantitative Easing

Will it be enough to stop inflation?

Who Knows? Seriously Who knows? Firstly the assessment here is dramatically over simplified. Another factor is the measurement itself. Inflation is calculated Year-over-Year (YoY), so the figures are compared to those 12 months in the past. Bringing inflation ‘Back’ to 1-2% doesn’t necessarily mean consumer prices will have gone down! If prices stay as they are, then in 12 months inflation would be 0%. Bringing prices back to 2020 levels would require a period of deflation.

The question becomes what is the target and what is the method. Perhaps another way to assess the question is to keep things simple. Supply, Demand and the value of money! Perhaps keeping things simple – keep things at the macro level to do a basic psychological analysis.

The more expensive money gets, the harder it is to service a loan. This will impact on bank loans and consumer serviceability, so no wonder the banks are predicting hurricanes! Higher rates will have immediate impacts on home owners and savings accounts, but what about your cost of living? Will a higher interest rate make the cost of your food cheaper? Will it make the cost of goods go down?

Well … hmmm  … directly … maybe not. Indirectly … hmmm, likely! If the goal is too cool the economy, to rebalance supply and demand, then commercial logic says you cant tune the supply side. Limiting supply or capping prices, can erode the profit margins of a business, making business unprofitable instead of cheaper. We want to cool, not kill businesses, and you can’t force businesses to over supply their goods. If the economy is cooling, companies don’t want their money stuck on the shelf!

That means, demand needs to be tapered … we need to see ‘demand destruction’ … quite literally having the consumer walk away from goods and services, in order to drop pricing. That means … consumers either needs to choose to cut back, or have the decision made for them, to remove buying power and remove the buying choice too.

This is why things have to be done so carefully and why no matter what happens, hindsight will not be kind to any decision. Already the calls have been that action has been too slow, and calls are already suggesting action is too aggressive. Destroying demand – rebalancing the supply and demand dynamic is the aim … but there is one fact that cant be ignored.

Energy! We’re not just talking about prices rising. We’re talking about the cost of manufacturing and transport rising. When every unit of measure is 40% more expensive, those prices have to get paid. Manufacturers will absorb as much as they can to a point, but at the end of the day the consumer always pays. As long as the cost of energy remains high – where every aspect of daily life requires energy, at the most expensive prices its ever been, the costs of life and business have never been higher, and that means prices will stay high, until the cost of doing business … the cost of living start to drop, and that starts with the cost of energy.

One thing is for sure – when industry leaders, and business owners … when people like Elon Musk say they have bad feelings about what is coming … its time to take notice.

Will interest rates stop inflation? Not how we think!

1,595 Words … Nailed it!

Related: Why is it so Hard to start a business?

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