The Link Between Rates, Jobs and Inflation has Changed

U.S. headline CPI inflation has had an impressive surge and an equally impressive reversal. Are Americans heading back to the good old days of persistent low inflation? Unpacking the trends in CPI and their causes suggests not, with important implications for all of us in the real economy.

The rapid decline in headline inflation is occurring primarily due to the causes of the price surge being removed.  Or, as Will Rogers famously observed: “if you want to get out of a hole, stop digging”.  When the COVID pandemic hit, 22 million U.S. workers lost their jobs.  Then U.S. policymakers provided $5 trillion of government spending to cushion the blow, which was financed by $5 trillion of Federal Reserve purchases of Treasuries and mortgages. 

The massive spending surge on goods triggered supply chain challenges, making the inflation surge all the worse.  As the inflation problem was recognized and the pandemic faded away, no further government stimulus was provided, the Fed started to raise rates and shrink its balance sheet, and supply chain disruptions were resolved.  In short order, with the causes in reverse, headline inflation began to recede.

Core inflation has been a different story because the shelter component of the price index is rising at an 8% rate and receives about 40% of the weight in the index.  Part of the problem is simply in the way shelter prices are calculated in terms of homeowner equivalent rent.  It is an arcane and lagged calculation based on a formula of how much a homeowner would charge to rent the house.  In the last few months, we note that rental housing inflation is running at about 0.5% per month or a 6% annual rate — still high but starting to moderate.

There is also the debate concerning why higher interest rates have not caused a recession or unemployment to materially rise.  The link between rates, jobs, and inflation has dramatically changed over the decades.  Back in the 1950s and 1960s, the U.S. economy was driven by manufacturing and housing.  Many financial institutions had at their core a business plan of borrowing short-term money from depositors or savers and lending longer-term for houses or automobiles.  The interest-rate risk embedded in this business model was huge and not easily hedged, so when rates went up, the economy went down.  

Fast-forward to today’s service economy.  Home mortgages are originated and then sold to institutions or funds willing to hold them.  Interest-rate risk is efficiently managed through interest rate derivatives such as swaps, futures, and options, which did not exist in the 1950s and even into the 1970s.  

Taking interest-rate risk is now a choice, not a business model.  And the result is that the U.S. economy is much less-sensitive to rate changes.  Yes, rate hikes matter, but now more for the value of stocks, bonds, and houses than for the functioning of a real economy with the tools to manage the risks.  And so, the widely forecasted recession based on rising rates has not happened yet.  

Eventually, maybe some unexpected disaster may tilt the U.S. economy into recession, but still popular, outdated economic models vastly underestimate the resilience and robustness of the economy.