As the pandemic raged in August 2020, the Federal Reserve signaled a major policy shift by changing its inflation target from a fixed rate of 2% to an “average” rate of 2%. This step was an acknowledgment of the difficult short-term economic conditions ahead. Fast forward to year-over-year (all goods) inflation of over 8% in March, April and May 2022. In response, the Fed raised its policy interest rate by 25 basis points, 50 basis points and 75 basis points in March. , May and June 2022, respectively. In total, the Fed will likely raise rates an additional 150 to 175 basis points in 2022.
We support raising rates, not as a cure for inflation, but to allocate capital more efficiently. We have long argued for the Fed to raise interest rates more aggressively during the recovery from the financial crisis, because slightly higher rates better allocate capital and fuel growth, not dampen it. For this reason, we are not concerned that Fed rate hikes will hurt growth. On the contrary, up to a point. Higher rates cannot offset supply shocks such as floods, hurricanes, wars, or shutdowns.
Many experts warn of an economic collapse as interest rates rise. But contrary to Keynesian theory, artificially low rates inhibit growth by badly affecting capital. A major problem with low interest rates is that large borrowers, especially the US government, have little or no fees associated with spending “free money”. The economic inefficiency of zero percent interest rates is underscored by the fact that depriving retirees of income from their lifetime savings cannot be a sensible economic policy, since theft is an involuntary exchange. And giving free money to the 535 fiscally irresponsible members of Congress who determine the spending of the world’s biggest borrower can’t be smart. If something that is not economically free is made free, it will be overused. That’s not to say that higher interest rates will make Congress fiscally responsible, but it will help.
After the June rate hike, the Fed Funds target rate was between 1.5% and 1.75%. The effective federal funds rate rose from 0.83% to 1.58%, while the discount rate and yields on 10- and 30-year Treasury bills rose to 1.75%, 3.3% and 3.4%, respectively. Even if the Fed raises nominal short-term rates to 2.5% by the end of this year, the real short-term rate will still be negative and growth will continue. Remember that the US economy and your business did very well when rates were at these levels in 2019.
We suspect further rate hikes this year are already priced into the market. As the balance of supply and demand across the economy normalizes, interest rates will also normalize. And since the economy’s resource allocation will improve because money is no longer free for borrowers, the economy will grow unless the Fed raises rates too much. We don’t know exactly what this inflection point is, but we believe it is well above current levels.
Dr. Peter Linneman is Director and Founder of Linneman Associates and Professor Emeritus at the Wharton School of Business at the University of Pennsylvania. www.linnemanassociates.com
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