The stickiness of the post-pandemic inflation is raising questions about how effective high interest rates are at bringing down price increases – and if they could be fueling the problem.
Standard economic thinking says that higher interest rates should bring down prices by squeezing the labor market and lessening the demand for goods and services. Lower demand then forces companies to cut their prices.
Inflation began a rapid descent in the middle of 2022 but has remained above 3 percent for nearly a year, ticking up to 3.5 percent in March. Some experts are now questioning the logic behind rate hikes and asking if they may even be stimulating the economy toward further growth rather than slowing it down.
For that to work, the extra money made in the form of interest income from higher rates would need to be making its way back into the economy through consumer spending, thereby adding more fuel to price increases.
Investors and wealth managers say they’re seeing the signs.
“It’s people who have piles of cash that are generating more cash faster than they can spend it,” Ritholtz Wealth Management CEO Josh Brown said on the CNBC television network last week.
“I work in wealth management … I’m telling you, this segment of the population is not only not pulling back because rates are higher, but in many cases they feel like they’re doing better than ever.”
The Fed is poised to keep rates at the current baseline range of 5.25 to 5.5 percent at its next policy meeting in May after several hot employment and inflation reports. Fed Chair Jerome Powell said last week that the central bank has yet to see desired “progress” in its inflation fight and is prepared to keep rates higher for longer.
“Recent data shows solid growth and continued strength in the labor market but also a lack of further progress so far this year on returning to our 2-percent inflation goal,” Powell said last week during a panel discussion.
But some experts fear that the Fed’s decision may be working against its goal of slowing the economy into lower inflation.
“[The Federal Reserve] thought that they would be slowing the economy, but they’re actually strengthening the economy,” investor David Einhorn, founder of hedge fund Greenlight Capital, said on a Bloomberg podcast in February. “I think that’s why we have this really strong GDP growth that is persisting right now.”
Federal debt levels, which are now at record highs as the yields on U.S. treasuries hover near a 20-year peak above 4.5 percent, could be further fueling this dynamic, putting billions more dollars into the pockets of bondholders.
“If interest rates are 4 percent or something like that, you’re paying out 4 percent or more of GDP in interest,” Einhorn said. “And so you’re paying out a big percentage of your tax collections in debt service, even before you get to what you actually want to have.”
The notion that interest rate increases may actually be stimulative rather than restrictive has long been a tenet of modern monetary theorists (MMT), a subset of economists who argue that government deficits are the norm of fiscal policy rather than the exception.
MMT economists have been paying attention to the acceleration of growth in gross domestic product (GDP) over the past year, which has occurred along with interest rate increases.
“Are we at the tipping point where the interest payments are finding their way into the hands of enough people who are turning around and spending them into an economy that can’t keep up with supply? Then you could anticipate some reacceleration,” Stony Brook University economist and MMT proponent Stephanie Kelton told The Hill in a February interview.
“We’ve seen inflation continue to step down while growth has accelerated. So if the Fed’s rate hikes were really working the way [Fed chair Jerome] Powell [has tried] to convince us they are, you have to scratch your head and say, ‘How do you define working?’”
These are open questions in the economy now because the extent to which interest income translates to consumer spending isn’t tracked by government data.
An official with the Commerce Department told The Hill that it’s not possible to measure how much consumer spending comes from interest, compensation, dividends, and other revenue streams. The Fed did not respond to questions for this article about the relationship between interest rates, spending and levels of demand.
In the past, Fed officials have acknowledged that interest rate increases can drive up prices on interest rate-sensitive sectors of the economy, notably in housing costs.
However, personal interest income has accelerated since 2021 and is now near an all-time high.
Other economists take issue with the notion that interest income may be driving demand and suspect the effects of it are small.
“My guess is that the amount of additional consumption spending spurred by higher interest payments is relatively small,” economist Dean Baker with the Center for Economic Policy and Research, a think tank, told The Hill. “Most of the interest income is not going to people directly. It goes to pension funds, banks, and insofar as it goes to people it is largely through holdings in 401(k)s and other retirement accounts.”
However, pension funds have been moving funds from stock portfolios to bonds as returns have been increasing.
“Pension funds, because they can finally get a yield in the bond market, may be reallocating money from stocks to bonds, because they don’t need to chase that anymore,” investor Axel Merk, founder of Merk Investments, told The Hill.
If interest income has in fact become a driver of inflation, the Fed’s logic on using rate hikes to slow economic activity may be all the more controversial due to the fact that only a fraction of U.S. households actually make money from interest.
Less than a fifth of U.S. households have income derived from interest, dividends or rental income, according to Census Bureau data.
“Maintaining the unequal pain of higher rates hurts lower-income groups for longer, while potentially helping higher-income groups,” UBS economist Paul Donovan wrote in Friday note to investors.
“Bizarrely, it might turn out that for the top ten percent of households by income or net worth, really high yields … actually might be stimulative,” Ritholtz’s Josh Brown said.
Adding to the controversy is the extent to which outsized profit margins, enabled by fiscal stimulus, have contributed to inflation, another open question about current economic conditions that have been noted in recent Fed Beige Books, though the trend seems to be in decline.
“The Fed’s Beige Book of anecdote strongly suggested profit-led inflation is retreating as consumers rebel. However, benign inflation anecdotes do not automatically translate into lower headline inflation—it is administered and made-up prices that are propping up inflation, not market-determined prices,” Donovan said.
