Abstract
A strict linear proportionality between the CPI inflation and the actual interest rate defined by the Board of Governors of the Federal Reserve System is studied. During the last 70 years, the cumulative CPI is just the cumulative interest rate times 1.37. There are periods when the Fed interest rate deviates from the long term inflation trend driven by the CPI. In this paper, we use the observational dataset provided by the Economic Resources & Data of the Federal Reserve Bank of St. Louis. The difference between the cumulative curves of the CPI and the Fed rate divided by 1.37 is periodic. The recessions observed after 1955 are well synchronized with the kinks and turns in the difference curve. The most recent recession as related to the peak in the difference was expected in 2020, but was likely mixed with the COVID-19 induced recession. The current Fed rate is not high enough to return the difference to the zero line in before 2030-2040. The last 6 months have been lost for the compensation of inflation with a higher Fed rate. The risk of recession has been increasing fast.
Observations
The CPI and the Federal Funds
effective rate data between 1954 and 2024 are available from the Economic
Resources & Data of the Federal Reserve Bank of St. Louis [1]. In Figure 1,
we depict the effective rate, R, and
the monthly estimate of the consumer price inflation, CPI, for the previous 12 months (not seasonally adjusted). One can
see that R lags behind the CPI since
1980, i.e., inflation grows at its own rate and R has to follow up. The idea of interest rate is that a higher R should suppress price inflation when
it is high due to the effect of expensive money. During the low inflation or deflationary
periods with 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 immediately but
with some time lag.
Therefore, the idea of the Fed rate influence on the consumer price
inflation is based on some cumulative effect of the change in money price for
the economy. It would be instructive to look into the cumulative curves of both
the CPI and the Fed rate in an attempt to confirm the influence of the latter
on the former parameter. The cumulative influence of the interest rate should
produce a desired effect in the long run and inflation should go in the
direction towards the values acceptable for the FRS. Figure 2 displays the
cumulative curves of the monthly estimates of R and CPI. At first
glance, both curves are very similar and evolve in sync but at different rates,
i.e., with different slopes.
We have estimated the best coefficient to fit both curves as 1.37
(interestingly, this is similar to the fine structure constant α=137 in
physics). Figure 3 displays the resulting curves. We have added vertical lines
to present the recession periods as reported by the National Bureau of Economic
Research (NBER) Business Cycle Dating Committee [2]. This is an intriguing
plot. In the long run, the R curve
fluctuates around the CPI one and
returns to it. (We consider CPI as an independent endogenous economic
variable.)
Finally, Figure 4 presents the difference between the cumulative curves. Most recently, this difference 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 March 2023 was
3 quarters after the technical recession: two subsequent quarters with negative
growth rates in Q1 and Q2 2022. If to consider the Fed behavior 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.
Figure 1. The monthly
estimates of the Federal Funds effective rate, R, the rate of consumer price
inflation, CPI, between July 1954 and August 2024.
Figure 2. Cumulative values of
the two curves in Figure 1.
The
broader picture in Figure 4 is even more interesting to discuss in details.
Firstly, the difference is very close to periodic behavior. The previous peak
was near 1980, i.e., ~45 years ago. The
previous trough was observed in the beginning of 2000s. The amplitudes of the
peaks and troughs are similar: from 1.8 in 1980 to 2.0 for the most recent. The
amplitude of the latter could be an artifact of the longer zero-Fed-rate policy
during the very slow recovery after the 2008 recession and the COVID-19
pandemic.
When
looking into the recession periods observed since 1955 and comparing them with
the kinks and turns in the CPI-Fed rate difference in Figure 4 one may have an
impression that the former are most often coincide with the latter. The only
important exclusion is that the 2023 peak was not marked any recession. The
2020 recession is exogenous and fully related to the COVID-19 pandemic. Or not?
Can it be that the peak in 2023 is not linked to a new recession, but the 2020
recession was forced by the expected 2020 CPI-Fed rate peak smashed by the Fed
actions forced by COVID-19?
Figure 3. Same as in Figure 2, but R
is divided by 1.37. Vertical lines present the recession periods as reported by
the National Bureau of Economic Research (NBER) Business Cycle Dating Committee.
Figure 4. The difference
between the CPI and R curves in Figure 3. (upper - updated
Jan 2025, lower - the previous version 6 months
ago)
The
2023 peak was artificially high, but it has to be followed by a fast fall in
the difference. With high inflation in 2022-2023 the Fed rate has to be high as
well. It seems this rate was not high enough to suppress inflation in sense the
lower and earlier peak in the difference and further drop according to the
slope observed in the 1980s. With the Fed decision to quickly reduce the
interest rate in the next 4 to 6 quarters, one can expect that the difference
will not be falling at all. The effect of high difference during extended
periods is not clear, but the difference has to come back to the zero line at
some point in the next 10 to 15 years. One needs to follow these phenomena.
Figure
5 presents a prediction of the CPI-R difference growth during the next 5 years if
the CPI and R will be the same as now. The risk of recession has been growing as
the price growth is to high compared to the savings benefits. The US economy has
to shrink as it is driven by demand and the personal consumption has to fall.
Figure 5. The difference
between the CPI and R/1.37 curves in Figure 4 if the
current difference in CPI and R will the
same
References
1. Economic
Resources & Data of the Federal
Reserve Bank of St. Louis (Consumer Price
Index for All Urban Consumers: All Items in U.S. City Average (CPIAUCSL) | FRED
| St. Louis Fed (stlouisfed.org)). Retrieved on September 15, 2024.
2. The National Bureau of
Economic Research (NBER) Business Cycle Dating Committee. Business Cycle Dating | NBER. Retrieved on September 15,
2024.
