Maybe Rate Hikes Are Helping the Economy?

David Grimaldi, Foreign Exchange Sales Consultant

For most economists is it blasphemy to say that raising interest rates could be beneficial for an economy. The yield curve has been inverted now for almost a year, which has been a steady indicator of a future recession. But where is this recession we have been waiting for and why is the economy still showing signs of strength? In Federal Reserve Chairman Jerome Powell’s own words, rate hikes are intended to “break stuff” and create unemployment. We saw some indications of stuff breaking last March in the regional bank sector, but that has proven to be limited. There could be additional failures in 2024 as New York Community Bank rating was cut to junk. Despite this, the talk among Fed presidents is minimal to no hikes this year, with inflation and growth trending back up.

Source: Bloomberg
Note: *average of previous two quarters

The truth is the rise in rates from 0% to 5% has created a stream of income for savings and bond holdings. Americans now have money for purchase and to reinvest for the first time in decades. The unprecedented printing of money over the last four years has not entirely been flushed out of the economy. In the 1970s, Fed President Paul Volker broke inflation’s back by raising rates to the true inflation rate. Until that is done presently, the raising of rates is just making richer people richer, and inflated goods more expensive for the poor. Fed rates hikes have not driven down demand for goods; in fact, it may have created the opposite effect.

• U.S. households receive $13 trillion of short-term assets — outpacing $5 trillion of consumer debt.
• Factoring out interest on mortgages, that is a net gain of $400 billion for Americans.
• Retirees are the biggest beneficiaries of higher rates — 42% of Americans own their home outright and most of these are retirees, who can put money in other interest-bearing assets.
• Many homeowners with debt locked in lower rates during COVID-19. *

Mark Zandi, chief economist at Moody’s Analytics, spoke for the traditionalists when he called the new theory simply “off base.” But even Zandi acknowledges that “higher rates are doing less economic damage than in times past,” he told Bloomberg.

Inflation Can Be a Benefit for People in Debt

As inflation rises, wages eventually have to keep up with it due to competition for labor. If someone borrowed money before inflation occurred and their wages have increased, they could benefit since the borrower still owes the same amount of money, but they have more wages to pay off the debt.

This does not hold true for those who are accumulating credit card debt because of inflation, which has now skyrocketed to $1.12 trillion in the U.S. at an average 22.3% rate.

Exploding Budget Deficits Are Causing this Phenomenon

David Einhorn of Greenlight Capital explains that government debt at $35 trillion has doubled in the last decade, and the higher interest rates on that debt has translated to $50 billion dollars to domestic, and foreign borrowers $600 billion dollars, annually.

Summary

Powell said the week of April 21 there has been a lack of further progress on inflation to come back to the 2% goal. “The recent data have clearly not given us greater confidence, and instead indicate that it’s likely to take longer than expected to achieve that confidence,” he said.

Unless the Fed is willing to do what Volker did to end inflation, the depositors and bond holders will continue to benefit. It is unlikely in an election year that the Fed would take such steps that could really break the economy to get us on a path to lower inflation. Instead, we may see no cuts, and maybe even gradual hikes.