Fighting Inflation And The ‘Real’ Cost Of Borrowing

The Federal Reserve is supposedly “fighting inflation.”

But, is it?

The Federal Reserve has, so far, pushed the upper bound of its policy rate of interest, the Federal Funds rate, up to 2.50 percent.

The effective Federal Funds rate has been at 2.33 percent since the latest move was made on July 27, 2022.

The yield on the 10-year U.S. Government note is around 2.80 percent.

The term structure of interest rates is negative and has now been negative for several weeks. This is usually a sure signal that the economy is going to go into a recession, if it is not already in one.

Furthermore, many members of the Board of Governors of the Fed are sending out signals that the policy rate of interest must go higher.

And, what is the stock market doing?

Well, since the Fed made its most recent interest rate move, the stock market has risen.

For example, the Standard & Poor’s 500 Stock Index closed at 3,921 on Tuesday, July 26, the day before the Fed made its latest move.

On Wednesday, July 27, after the Fed raised the range of its policy rate of interest by 75 basis points, the second 75 basis point move in two months, the stock market rose to close at 4,024.

On Thursday, the S&P jumped to close at 4,072 and then ended the week at 4,130 on Friday.

Monday and Tuesday, the market fell, but on Wednesday, August 3, the market turned up once again. Around 1:00 pm on Wednesday, the S&P was up to 4,157 to erase the losses on Monday and Tuesday.

Investors just cannot seem to keep stock prices falling in the face of Fed moves to take interest rates higher and Fed officers talking to back up the rise in rates.

In addition, the Federal Reserve has actually begun to reduce the size of its securities portfolio.

Yet, investors continue to push stock prices higher.

Comparison With The Early 80s

People just cannot seem to leave the 1980s alone.

Phil Gramm and Mike Solon have an opinion piece in the Wall Street Journal that discusses the “Lessons From the Great Inflation 1973-81.”

They take a look at the situation from the perspective of fiscal policy.

That is not what I want to do.

What struck me in their piece was the introduction of the information that inflation in the United States, between 1973 and 1982 averaged 9.2 percent.

Why did this inflation number hit me?

Well, it hit me because the Federal Reserve had to raise its policy rate of interest, the Federal Funds rate, above 22.00 percent. This was achieved in December 1980.

In other words, the Federal Reserve had to raise its policy rate of interest to such a high level because the rate of inflation was so high, being above 9.0 percent.

I remember the discussions at the time. The Fed had to raise the Federal Funds rate so high because, if it didn’t, the “real rate of interest” that borrowers paid on their borrowing remained negative if the nominal rate was not so high.

In September 1981, the yield on the 10-year U.S. Treasury note was almost 16.00 percent.

Again, the high interest rates were necessary to make borrowing costly in a real sense

And, the nominal interest had to be sufficiently high enough and maintain relatively high spreads for a reasonably long period of time to convince borrowers that there was a positive real cost to their borrowing.

Until the Federal Reserve pushed its rate up to such high levels, the cost of borrowing remained negative…in real terms.

It was painful…very painful…to have such high interest rates, but Federal Reserve chairman Paul Volcker believed that this pain was a necessary cost of getting inflation under control.

And, Mr. Volcker proved to be correct.

The Current Situation

In July, the rate of inflation in the United States was 9.1 percent.

Inflation has not been this high for too long a time, certainly not 9 years as in the 1973-1982 period.

And, with the Federal Reserve moving as it has, inflation, hopefully, will not be so high for so long.

But, the rate of inflation was 9.1 percent in July.

The effective Federal Funds rate is now 2.3 percent.

The “real” rate of interest, therefore, to someone that can borrow at this rate is a negative 6.8 percent.

A real borrowing rate of a negative 6.8 percent is not going to stop people from borrowing.

So, the Federal Reserve has a lot of work still to do.

Even if one assumes that the actual average inflation rate these days is just 6.00 percent, a 2.3 percent borrowing rate is not going to stop people and businesses from borrowing money.

How high does the Fed need to raise its policy rate of interest?

The earlier episode, in the 1980s, had the Federal Funds rate going up to 22.0 percent when the average inflation rate was around 9.0 percent.

If our current average interest rate is around 6.0 percent, will the Federal Funds rate have to go to 10.00 percent to bring inflation under control?

If this is the case, then the Federal Reserve has a long way to go.

And, if this is the case, then investors have support in their thinking that stock prices should go higher.

Question: if this argument is correct, then the stock market could be a good indicator of just how tight the Federal Reserve really is.

As long as stock prices continue to increase, one could argue it is a sign that the Federal Reserve has not approached a level of its policy rate that is in any way restrictive.

Thus, investors can continue to invest.

However, if investors become convinced that the Fed really is going to continue to raise its policy rate to the point where the “real” cost of borrowing becomes significantly positive so as to slow down or stop borrowing, then the stock market will decline, and could decline by a significant amount.

The key here is how much confidence does the investment community have that the Fed is really intent upon stopping inflation.