Ok, so the world’s central banks did the hard part and raised rates at the fastest pace in decades. So why are we still reading about persistent inflation?
Rate hikes typically work at reducing demand, which will usually reduce inflation as we measure it, but with a long and variable lag. It is the lag that is causing angst amongst the world’s policy makers.
This lag makes sticking the inflation landing extremely difficult because they have to wait months to see if the things they did a long time ago were effective or not.
Chances are the Fed already raised rates too much, but it’s too early to tell for sure. The economy is like a big ship that takes its time to turn. You can apply a lot of rudder, but there is a tremendous amount of momentum that needs to be coerced into a different direction, and that doesn’t happen immediately.
The effects of a rate hike lag filter through the economy in a series of waves, with one wave effecting the behavior of the other.
The Fed only controls the overnight rate that banks charge each other for funds that they need to have on their balance sheet. While that might not directly affect you or I, it indirectly does, because everything else tends to key off the Fed Funds Rate.
These short-term rate changes steer other borrowing costs in the economy like deposit and lending rates for you and I, and commercial lending rates that businesses must pay.
These rates take time to change. For example, you might be under contract to buy a home, and from the time you are quoted a rate to the time of closing, weeks or even months can pass. This is just one example of how inflation lags. According to the IMF, interest rate changes have their peak effect on growth in about one year and it takes a full three to four years to have the desired effect on inflation. Looking back, the central banking legend Paul Volcker took office during the raging inflation that occurred in 1979 and almost immediately pushed rates to an eye watering 20%. That quickly caused a major recession, but even then inflation took about three years to fall to manageable levels.
Higher borrowing costs had to bleed their way into the economy. That meant weaker sales, which pressured prices and wages. These things work, but they take time. In the meantime, it is a wild guess on what the “just right” Fed Funds Rate is.
Currently, the market has priced in a 95% probability that the Fed will raise rates by another 3/4 point in their November meeting, and then reassess how much to raise in the meeting after that. That means at least two more likely consecutive hikes before the Fed goes into wait and see mode to see if the desired changes to the economy did indeed occur. The thing is, nobody knows if the Fed did enough, or already did too much. It will take months for us to find out.
While a 3/4 point increase for November is all but assured, investors aren't nearly so confident about what the Fed will do in December. Some expect another 3/4 point hike, while roughly an equal amount are expecting only a half point increase. Whether it is a half or a three quarter point hike, we don't know. But, the market expects the Fed to stop with their aggressive hiking campaign and then sit back and see what the consequences are for the actions that the Fed already took.
It will take a little while before we will know whether the Fed did enough or too much. In the meantime, now you know that the Fed is guessing what the right rate should be, and they are always months behind confirmation on whether their policy stance is accurate or not.
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