You Can't Have Both: Low Rates and Low Inflation

FED Cuts Interest Rates Again

Today, on Monday, November 11th, the FED will yet again cut interest rates, lowering the Federal Funds target rate by 25 basis points. On November 8th, FED Chairman, Jerome Powell, gave a press conference announcing and rationalizing the FED's decision by making a series of false and contradictory claims: "the economy is strong overall," the labor market is "cooling," and inflation "has eased substantially."

All of that is nonsense.

In the first place, Powell says the economy is "strong" and that the labor market is "cooling." But both of these can't be true at the same time. If the labor market is in decline, then production and consumption are in decline, too. This means private sector GDP is in decline, and that economic growth, therefore, is either slowing or negative. That doesn't exactly indicate strength. Furthermore, the FED only cuts rates when the economy isn't doing well, anyway (That's, like, half their reason for existence, man!). Implicitly, then, any FED action to lower or raise interest rates is an admission that the market isn't performing as desired. Remember, also, that the official jobs report for October showed a loss of 28,000 private sector jobs offset by 40,000 new government jobs, while the much more reliable Household Survey showed a loss of 360,000 jobs! So no, the labor market isn't "cooling"––it's freezing to death. Powell and the FED know this.

Second, Powell is also wrong about price inflation. Powell claimed that "[Price] Inflation has eased substantially from its peak of 7% to 2.1% as of September." First off, the 7% rate wasn't even the peak. The FED's preferred measure of price inflation––the PCE Less Food and Energy index––peaked at 5.6% on a year-over-year basis, and is currently reporting price inflation at a rate of 2.65%. For whatever reason, Powell decided to report figures from the less favored PCE: All Items index to summon this reassuring, good-sounding statistic of 2.1%––probably because he's loath to remind people that his Federal Reserve created 16% annualized inflation  in June 2022 according to the CPI: All Items index. So why did Powell cite figures from the FED's less favored version of PCE? To exaggerate the decline in the rate of price increases.  2.65% price inflation isn't anywhere near 2% in economic terms, let alone the FED's official policy objective of maintaining average price inflation at a rate of 2%. So much for consistency...

Importantly, given the FED's "average 2% target" of price inflation, reporting the 2.65% figure from the FED's usual price index would mean that the FED hasn't achieved its target of average 2% price inflation and can't cut interest rates yet! Rest assured that Powell's cherrypicking of these inflation numbers is entirely by design. To explain: whenever the FED reports (or the BLS, for that matter) the rate of price inflation they almost always cite the figure from the CPI: Less Food and Energy index (Core CPI) or Core PCE because both systematically underreport price inflation by excluding the categories of food and energy. However, the recent decline in global oil prices has made the CPI: All Items and PCE: All Items indices plummet below their favored Core indices, hence the reason for Powell citing the figures from the alternative inflation measure.

Powell's misrepresentation of these facts is merely an excuse to engage in more futile attempts to avoid recession by printing money to lower rates.

Trump! You Can't Have Both!

While on the campaign trail and many times since then, President-elect Donald Trump has frequently criticized Biden, Harris and Powell for their poor management of the economy. In particular, both as president and candidate, Trump has taken aim at Chairman Powell for raising rather than cutting interest rates, while also criticizing the Biden-Harris regime for massive levels of price inflation.

Consequently, Trump has made an impossible promise to Americans: lowering interest rates while also lowering price inflation.

These two goals are entirely at odds with one another and cannot be achieved simultaneously. Trump and his administration will have to advocate for either low rates or low price inflation, but not both. The obvious choice here is to do as Reagan and Volcker did and wring inflation out of the economy at the expense of lower interest rates––a painful but necessary course of action. 

But unfortunately for us, Trump has opted for low rates and has no choice but to work with Powell for the next two years. Trump ought to be happy with Powell at the moment given that he is dead set on continuing to cut interest rates. However, Trump has more or less burned his bridge with Powell after ruthlessly chastising him for raising rates in 2020. This is especially awkward since Powell put the mutual hostility between he and Trump on full display last week, stating that he would not step down at Trump's request:

With respect to interest rates and the economy, so concerned with the cost of living is Trump that he has even taken a page from Joe Biden's book by supporting caps on credit card interest rates (see: Credit Card Debt: Price Controls, Delinquency and Inflation).

This and other plans to manipulate or otherwise "set" interest rates is a stark reminder of the duty to prevent a Trump administration from meddling in the economy and doing more of what has ailed us. The high interest rates of today are the FED's necessary response to the inflation of yesterday; an inflation which they created by conjuring $6 trillion from thin air to fund the deficits, stimulus checks and renewable energy handouts of the Biden-Harris regime.

These sorts of policy proposals leave much to be desired in the coming Trump administration, regardless of how grateful we may be for his victory.

Trump's desire to lower interest rates and price inflation demonstrate a serious lack of awareness as to how FED policies are actually effected. In short, low rates and low price inflation cannot be achieved simultaneously because the creation of money (i.e. inflation) is precisely the way in which interest rates are lowered. Not to mention, creating money is what causes prices to rise in the first place (see: Econ 101: Inflation)!

The Mechanism

To illustrate this, four graphs appear below. The first three graphs show the relationship between FED monetary policy and the quantity of money. The fourth graph shows the relationship between the quantity of money and the Federal Funds rate (FFR). Stated logically, a change in monetary policy changes the quantity of money, and changes in the quantity of money then change interest rates.

The way in which the FED affects interest rates is via changes in the quantity of money––the money supply. The FED has a monopoly on money creation and so can manipulate the quantity of money in the economy. To do this, the FED tends to engage in Open Market Operations (OMOs) or, more recently, it changes the Interest Rate On Reserve Balances (IORB) paid to banks who keep money in their Federal Reserve accounts. The first graph shows how the FED's OMOs change the quantity of money (called M2) in the economy.

Take note of the spike in FED assets that occurred in 2009 and 2020. During these periods, the FED bought huge amounts of U.S. Treasuries and Mortgage-Backed Securities. By buying these assets, the FED gave newly printed money to the sellers (banks) of these assets which increased the quantity of money in the economy. Look at the graph below to see how the FED's purchase of these assets increased the money supply.

The change in the quantity of Treasuries and MBSs tracks almost perfectly with changes in the money supply. As the FED buys more and more assets, the quantity of money goes up. Thus, an increase in the FED's assets increases M2, while a decrease in FED assets decreases M2. However, the FED engages in more than just OMOs to affect the money supply, so changes in M2 don't always reflect changes in the FED's assets––hence the reason for the next graph. 

The graph below shows the relationship between IORB and M2. When banks keep money in their Federal Reserve accounts, the FED pays them interest on those deposits with newly created money. However, this relationship is an inverse one. If the FED pays banks higher interest on these reserves, banks will deposit more of their money (just like you and I would) in their accounts, thus lowering the quantity of money. Therefore, an increase in IORB decreases M2, while a decrease in IORB increases M2. Put differently, if the IORB is lower, banks have less incentive to keep that newly created money in their accounts and will begin searching for borrowers to lend to, increasing the quantity of money.

The IORB tool is the newest and now "go-to" tool of the FED. First implemented in 2021, the FED increased the IORB dramatically in an attempt to stifle further increases in the money supply and the price inflation that results. Then, in September, they lowered the IORB rate by 50 basis points (or by .5%) causing M2 to increase, and again lowered the IORB rate today by 25 basis points (or by .25%), which will cause M2 to increase further still.

Now that we've established the relationship between FED policy and the money supply, let's look at the relationship between M2 and interest rates. In particular, we are interested in the Federal Funds rate (the FFR). The FFR is the interest rate that banks pay when they borrow money from each other and is "the" interest rate that economists and others are referring to when talking about "rate cuts" and "interest rate targeting." It is a market interest rate and so is not set by the FED, but can be affected by them via their policies.

The graph above shows the change in the money supply plotted against the change in the FFR. Two things are of note here: first, the relationship is an inverse one and shows that as the FFR increases M2 decreases, while a decrease in the FFR causes M2 to increase. Second, large decreases in the FFR have preceded every recession going back to 2001 (the earliest FFR data). Rather than the FED mistakenly cutting rates and causing recessions, historically, the FED cuts rates in anticipation of, and in an attempt to avoid recessions. What does the FED know? Perhaps that the U.S. economy isn't "strong," that price inflation hasn't "eased," and that the labor market isn't "resilient." Evidently, the FED believes all of this. Otherwise, they wouldn't be engaging in monetary stimulus, now would they?

And so, interest rates cannot be lowered by the FED without creating money (inflation) and causing further price increases (price inflation). And price inflation cannot be stopped unless the FED quits printing money which would cause interest rates to rise (to their natural rate, by the way). Americans and the banking system are addicted to cheap credit and low interest rates. So addicted, in fact, that they've forgotten that 7,8,9 or 10% rates were normal at one point.

Their grievances are well understood considering that at these higher rates, many high-priced goods like homes and cars would become twice as expensive. But these things are already twice as expensive! That's not the fault of interest rates! That's the fault of the FED for continually debasing the Dollar, destroying the value of peoples' savings and wages, bailing out Wall Street to the tune of trillions, and causing prices to rise with ne'er an end in sight!

The Mechanism Restated

It is by the creation of money, injected into the banking system, that interest rates fall. The new money is given to banks who now have a greater supply of loanable funds. An increase in their supply then lowers the price of acquiring them––the interest rate. This new money is leant out by banks to businesses and entrepreneurs who otherwise could not profitably put this money to use at the previous, higher market interest rates. They then invest this money in projects which now appear to be profitable because of the lower interest rates. But the lower interest rates that result from the creation of this money do not reflect economic reality.

In a free market, interest rates fall when consumers save more of their money and put it in the bank. By saving, they are telling entrepreneurs that they are not going to spend their money to acquire resources today, but are instead willing to wait and acquire resources in the future. In essence, they tell entrepreneurs to use their savings to acquire the goods they are foregoing.

However, when the FED artificially lowers interest rates by creating money and injecting it into the banking system, entrepreneurs are misled into believing that consumers are foregoing consumption. They then wind up competing with consumers for resources they still want to consume. As a result, the prices of these resources are bid up higher and higher, giving the appearance of a "Booming" economy.

Alas, the competition between consumers and entrepreneurs continues, and entrepreneurs are forced to pay much more for resources than they anticipated. This eats into their bottom line and changes their assessments of their projects' feasibility. Some decide to abandon their projects and take the loss. Others remain stubborn and continue to bid for and acquire resources, and to acquire more and more financing from banks. Given enough time, these stubborn entrepreneurs eventually discover that their projects were not profitable and cease development.

This widespread closure of businesses––whether widespread or localized to a single or a few markets––constitutes the "Bust."

This is precisely the situation we have been in for the last four years and which is very quickly coming to an end. The decision of Powell's FED to cut rates during a period of severe economic sluggishness and high price inflation is a foolhardy attempt to keep the "Boom" going until Trump takes office. Trump's support for cutting interest rates does him no credit and leaves him wide open for attack should a deep recession hit early on in his term. Don't think that Powell and the FED haven't taken this into account. They most certainly have.

To protect the new Republican coalition and keep a left-wing resurgence at bay, prudence would dictate that Trump distance himself, immediately, from the policies of the Federal Reserve System. While Trump would be blamed regardless, at least denouncing rate cuts shifts the blame to those who truly deserve it––Powell and the FED.