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The Fed, Interest Rates, & Inflation

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I attended an OCON lecture of yours in '96 and you covered Greenspan's interest rate manipulation and its effect on the rate of inflation. My understanding of your explanation was the following:

I. The conventional argument for the Fed's raising interest rates (Federal Funds rates?) is that it, essentially, makes dollars more expensive and, therefore, counters inflationary presssures. According to that conventional theory, this would cause other interest rates to lower to reflect reduced inflation.

II. Your argument, as I understood it, was that interest rates reflect two things (1) The basic risk of lending money, the opportunity cost of giving it up now for a return later and (2) the expectation that the future value of the dollar will be less than it is now. The second part reflects an offset to the expectation of the decline in the value of the dollar, as expressed in higher interest. Raising the Fed Funds rates, rather than lowering inflation, actually acts to raise expectation in the decline of the value of the dollar, causing inflation, rather than lowering it.

That last part is where I'm a little hazy and I would really appreciate a clearer and more comprehensive explanation as to exactly what is happening when the Feds raise (or lower) the interest rates over which they have control. Your explanation certainly does appear to better reflect reality than the conventional one, but I'm missing a clear understanding of the mechanics involved.



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This is Richard M. Salsman's reply to the question posed by alann. Note that this reply also answers penhosky's question posed here -->. Also note that Mr. Salsman has made a relevant report available free to our members, as an attachment to this post. FedRateHikesBoostInflation_5.10.00.pdf

I discuss these issues in Part I of my 4-part series on the Great Depression (The Intellectual Activist, June 2004, pp. 21-23); I've also published the relevant quantitative relationships (with explanations) for clients of my firm, InterMarket Forecasting, Inc. ("Fed Rate Hikes Would Only Further Boost Inflation," The Capitalist Advisor, InterMarket Forecasting, Inc., May 10, 2000 – available as an attachment to this post). Using decades of history, I establish the undeniable fact that Fed rate hikes tend to precede (by a year or so) a rise in the rate of price inflation – with greater rate hikes leading to greater accelerations in the price inflation rate; equally, Fed rate cuts tend to precede a decline in the rate of price inflation – with greater cuts leading to greater decelerations in the price inflation rate. The rate of price inflation (see more below) is that which the Fed "targets" when it changes its overnight (Fed Funds) rate. But Fed officials (and most economists) mistakenly believe that rate hikes "fight inflation" – i.e., lower the price inflation rate.

For precision and clarity, let's define our terms. Inflation is a decline in the purchasing power of money – in what a dollar will buy in terms of real goods and services. The purchasing power of the dollar declines whenever 1) its supply is increased (by the Fed) in excess of the demand for dollar balances, or 2) the demand for dollar balances declines relative to the supply of dollars (even if that supply is fixed or falling). Both the Federal Reserve and U.S. Treasury Department influence the purchasing power of the dollar, the former primarily by issuing supplies of dollars and the latter primarily by manipulating the demand for dollars (either through a policy of a "strong dollar" or "weak dollar" in foreign exchange markets). Most economists (and Fed officials) measure changes in the dollar's purchasing power by measuring only the effect of such changes on the dollar-denominated prices of a broad basket of goods and services – as reflected in the Consumer Price Index (CPI). The CPI today is 202, compared to 177 five years ago; take the reciprocals of these numbers (i.e., 1/202 versus 1/177 – or 0.00637 versus 0.00565) and you get a rough measure of the decline (-12%) in the purchasing power of the dollar over the past half-decade (from 0.00637 in 2001 to 0.00565 today). It's a "rough" measure of inflation because the CPI doesn't adjust for the fact that the quality of products and services usually rises over time and the CPI also doesn't account quickly for people substituting out of more expensive items into less expensive substitutes.

The best measure of the dollar's purchasing power is how much gold a dollar buys – because the quality of gold remains the same over time and gold is the only commodity in the world that is produced and accumulated (while all others are produced and consumed); the latter attribute of gold means that net additions (from new mining) to the (ever-increasing) above-ground stock of gold are no more than 1-2% per year; as a result, the purchasing power of an ounce of gold itself is quite stable over time; in turn, this means swings in the gold price primarily reflect not swings in the supply of (or value of) gold itself but rather swings in the value of the dollar and the demand for gold. Gold is always more in demand not for industrial (or even consumer) uses but whenever the purchasing power of the dollar is expected to decline (i.e., there's a rise in inflation expectations). As we'll see, fewer dollar balances are demanded when the dollar's value is expected to decline and interest rates are expected to (or actually) rise.

Today's gold price is $586/ounce, compared to $270/ounce five years ago; take the reciprocals of these numbers (1/586 versus 1/270 – or 0.00370 versus 0.00171) and you'll find a large decline (of -53%) in the gold-based purchasing power of the dollar. That's inflation. Notice that this inflationary trend has been depressive and bearish for U.S. stocks and the economy. Today's S&P 500 stock-price index (1239) is barely (2%) above its level of five years ago (1211) and, of course, it remains 20% below its peak of 1553 in March 2000, when the gold price was just $285/ounce. Meanwhile, today's U.S. Industrial Production Index (112.0) is only 12% above its level (100.4) of five years ago. In contrast, in the five years ending January 2001 (January 1996-January 2001) the gold price fell 35% (the gold-value of the dollar rose by 35%), the S&P 500 increased by 117% and the U.S. Industrial Production Index increased by 27%. Inflation (a decline in the purchasing power of the dollar) is bearish for stocks and economic growth, while both disinflation (a diminishing rate of decline in the dollar's purchasing power) and deflation (a rise in the dollar's purchasing power) are bullish for stocks and the economy. This is true when one looks beyond merely the last decade to all earlier decades.

Unfortunately, most Fed officials and economists today believe "excessively high" economic growth rates (or "excessively low" unemployment rates) "cause" price inflation rates to accelerate; thus to "fight inflation" (an otherwise worthy goal, but which would require the Fed to fight its own inflationary inclinations), Fed officials raise their overnight interest rate to fight economic growth (if necessary, even to cause a recession – a reduction in output). Such rate hikes certainly DO trash growth (especially after the yield curve has been inverted – with short-term rates above long-term rates), but these rate hikes do not "fight inflation." Instead they reflect and boost inflation. They reflect it because if money is expected to lose purchasing power over time lenders will raise the interest rates they charge, to compensate for the expected loss in the purchasing power of the principal they receive back at the end of the loan period; the Fed usually raises its overnight (Fed Funds) rate only after seeing other interest rates rise in this inflationary manner. Fed rate hikes also boost inflation because they 1) raise the cost of borrowing and of doing business and, 2) lower the demand for money balances. Now consider the second, more-neglected phenomenon. The "demand for money" means the demand to hold money balances – and money is defined as purchasing media (i.e., currency in your wallet plus the balance in your checking account). When short-term interest rates were just 1% people had very little to lose by holding more balances in such non-interest-bearing forms; but as the Fed raises interest rates (as it has, from 1% five years ago to 5.25% today), the loss of potential interest income from holding non-interest-bearing balances increases; people lower their demand for money balances (for non-interest-bearing balances). Doesn't a decline in the demand for any item lower its value? It does. In this case, it lowers the value (purchasing power) of money (the dollar). That's inflation. Thus Fed rate hikes only boost the price inflation (CPI) rate.

Consider only the latest history. Recall that the Fed began raising rates in June 1999; just before that, in year ending March 1999, the inflation (CPI) rate had been just 1.7%; in the following year (ending March 2000) the CPI rate more than doubled, to 3.8%. The Fed last began raising rates again in June 2004; just before that, in year ending March 2004, the CPI rate had been just 1.7% again, down from the 3.8% rate seen in the year ending March 2000, due to Fed rate cuts in 2001-2003; but in the following year (ending March 2005) the CPI rate nearly doubled yet again, to 3.2% – and over the past year it has accelerated further, to 4.1%.

The Fed, in raising its overnight rate to "fight inflation" is not unlike a dog that's chasing its own tail – except that, unfortunately, it is market-makers, investors and businessmen – not Fed bureaucrats themselves – who get dizzy and nauseous from the inane act.

Short of adopting free banking and the gold standard, the only way inflation can be "fought" by the monetary central planners is by them not causing it in the first place. In the U.S. the Treasury Department should target the price of gold in a narrow range (i.e., buy and sell gold in a narrow range around the current market price) while the Fed should cut the Fed Funds rate to a level consistent with a stable gold price (roughly 3%) – and keep it there indefinitely. Where are my friends in the Austrian Economics community on this analysis and prescription? Many of them claim I'm an "inflationist," because they believe in the conventional myth that Fed rate hikes "fight inflation" (and equally, that Fed rate cuts "cause" inflation – and alleged stock-price "bubbles"). I feel like I'm living in the Dark Ages – a rational doctor who opposes the witch-doctors I see insisting that they're helping the patient by bloodletting; when I oppose blood-letting as barbaric I'm told that I endorse disease and don't care to cure the patient.

Richard M. Salsman, CFA

President & Chief Market Strategist

InterMarket Forecasting, Inc.

1777 Fordham Boulevard - Suite 202-4

Chapel Hill, North Carolina 27514



IFI is an investment research and forecasting firm that quantifies market-price indicators to guide the asset allocation decisions and trading strategies of pension plans, asset managers, financial institutions and hedge funds.

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