The Fed rate will not likely be falling soon and fast

In 2022, we wrote in this blog about the strict proportionality between the CPI inflation and the actual interest rate defined by the Board of Governors of the Federal Reserve System, R. This previous post continued the thread of posts related to this issue. Briefly, the cumulative interest rate since the mid-50s is just the cumulative CPI times 1.37. Interestingly, there are periods when the interest rate deviates from the long-term inflation trend, which has been almost linear since 1972. Here, we extend the observational dataset to the period of the quickest inflation rise since the second part of 2021, and discuss the most probable reason why the FRS actually does not control inflation as such by presenting the actual economic force behind price inflation, as we described in a series of papers [e.g., 1, 2, 3, and 4].  Overall, inflation is a linear lagged function of the change in the labor force. The latter is driven by a secular change in the participation rate in the labor force (LFPR) together with a general increase in working-age population. In other words, increasing the labor force pushes inflation up, and decreasing the labor force leads to price deflation. The period of the COVID19 pandemic is the first one when helicopter money flooded the US economy and the inflation effect observed in 2021 to 2022 is explained by the natural dollar devaluation related to money excess.

Introducing new data obtained in 2023, we depict in Figure 1 the effective Fed rate, R, and the CPI inflation as expressed in the relative growth rate (1/year). In Figure 2, R is divided by a factor of 1.37 (see our previous post for details) to match the long-term trend in the consumer price inflation. Before 1980, R was rather in the leading position. Since the late 1970s, R lags behind the CPI, i.e. inflation grows at its own rate and R just follows. The sought level of the price inflation was flexible. The idea of interest rate adjustment is that a higher R should suppress price inflation. During deflationary periods with a slow economy, low (in some countries negative) R has to channel cheap money into the economic growth. The reaction of inflation is also expected not shortly but with some time lag.

Figure 1. The CPI inflation rate and the Federal Reserve effective rate, R.

Figure 2. The CPI inflation rate (monthly y/y CPI inflation rate) and the Federal Reserve effective rate, R, divided by 1.37 (R/1.37).

The cumulative influence of the interest rate should produce a desired effect in the long run, and inflation should go in the direction towards acceptable values or target inflation. Figure 3 displays the cumulative effect, i.e. the cumulative values of the monthly estimates of R/1.37 and CPI. This is an intriguing plot. In the long run, the cumulative R/1.37 curve fluctuates around the CPI one and returns to it. It is hard to believe that the sign of deviation of R/1.37 from the CPI curve affects the behaviour of the CPI, which is practically linear. Therefore, the efficiency of monetary policy is under doubt. The FRS has tried all means to return the CPI to R without any success and has to return R/1.37 to the CPI!

Figure 3. The cumulative monthly values of R/1.37 and CPI since 1955.Vertical lines show the documented recessions in the USA.

Figure 4 shows the difference between the two cumulative curves in Figure 3 – CPI-R/1.37. One can observe a periodic character of the difference and unreasonably high correlation of the recessions with the peaks and kicks in the difference curve. Currently, the difference is close to the peak value observed in 1980. The recession observed in 2020 is likely related to the COVID-19 socio-economic collapse.  With the current high inflation and low R, a recession in a new future seems to be a highly likely event. The FED lost the control on inflation despite their long-term task is extremely easy – just retain R at the level of 1.37CPI.

Figure 4. The difference between the cumulative R/1.37 and CPI. Notice the correlation of the peaks and kicks in the difference curve and the US recessions.

The difference in Figure 4 peaks in March 2023 and then slightly falls. This peak was expected and is a genuine reaction of the Fed to the dramatic surge in inflation during and after the pandemic. The money pumping into the economy was extraordinary and money devaluation was a natural reaction. The peak in the difference in 2023 was observed in March 2023 - 3 quarters after the technical recession - two subsequent quarters with negative growth rates in Q1 and Q2 2022. In to consider the Fed behaviour as based on rules and precedents,  one can expect that the positive deviation between the inflation and the Fed rate curves has to be closed within the next 20 years. The Fed rate has to be higher than CPI inflation times 1.37.  With the current rate of inflation, the Fed rate will not likely be falling fast.