In Whose Interest? Decoding the Phenomenon of Interest Rates in the US

The inflation levels in the United States reached a 40-year high today, touching 9.1%. The Federal Funds overnight rate reached 1.58%, and even the LIBOR (London interbank overnight rate) has reached the same level, standing at 1.57%. The Bank of Canada raised their rates by 1% today in response to the high levels of expected inflation and to account for the unexpected aspect of it. There have been conversations all around the place about the possibility of a recession, how the country and other economies might have reached a point of stagflation, why the increase in increase rates was inevitable and why the Federal Reserve might have created a recipe for disaster. The Covid-19 pandemic not only shook the healthcare systems and infrastructure around the globe but also brought the economic systems down. The GDP kept contracting for successive quarters, and things constantly seemed dim, as they do now. The unemployment rate in the US peaked at 14.7% when the pandemic was going on, and the GDP went down by nearly 10% moving into the second quarter of 2020, from the first quarter of the year. In a nutshell, everything has been catastrophic, especially in the US, because of how the healthcare infrastructure collapsed and the private debt proved risky during an uncertain period like this. If all of this was not enough, Russia's invasion of Ukraine proved to be another nail in the coffin. The attack shook the energy supply and severely affected the businesses in the US through rising commodity prices and affecting the operations of American companies in Eastern Europe. Given all of this, what really drives interest rates in an economy?

A DIVE INTO THE PAST

Rising the Federal Funds Rate has been associated with tightening the money supply, and the rates are usually increased when inflation is high and deleveraging is required. The opposite action is taken when there is low spending, and the productive activities need to be improved by printing more money. Now, the Federal Reserve does not print money or control the inflation levels, as all the consequences of the Reserve are indirect. It is done through buying and selling government treasuries in the open market and, most importantly, through playing with the psychology of people about their idea of an economy and the prevailing sentiment. Interest rates usually increase when the economy is doing well, and the productive activities are already pretty high, leading to a rise in the prices of general goods. Note that the Interest Rates and the Federal Funds Rate are two different concepts, as the Fed Rate is the interest rate at which banks can lend money to one another from the reserves with the Federal Reserve. In contrast, interest rates are what the economy expects while lending money with or without risk (subjected to risk premiums). According to the Fisher Equation, intrinsic interest rates can be assumed to be a function of inflation levels and the real GDP growth of an economy. 

The economy has hardly been doing well for the last 2 years, despite whatever one says about the post-pandemic recovery. The Nominal GDP tends to grow, but the Real GDP is certainly not, keeping in mind the high inflation levels. The Real GDP shrunk by 1.5% in the first quarter of this year, yet the interest rates have risen to deaccelerate growth, primarily due to the high inflation. It seems a little baffling as to what exactly is the reason for such high consumer prices and whether the rising of the Federal Funds Rate was a decision that should have been taken at this point. Does the Fed Funds Rate make a difference to the overall interest rates in the economy? The Fed Funds Rate has moved in absolute accordance with the inflation rates, which gives rise to a valid hypothesis about the Reserve being a follower and not having a significant impact on the interest rates. The Federal Funds Rate does not affect the interest rates in the economy in a direct manner but in a rather indirect way via the banks increasing the prime lending rate. Just to have an idea of the rates have fluctuated in the past decades, one can look at how the Fed Rates, inflation and the US economy have functioned together in the past:

• Pre-1990s: The era of the 1970s' can be skipped due to some reasons as the US economy, after coming off from a brief recession in early 1970, bought in the easy money policy to stimulate employment, resulting in high inflation. 1971 saw the gold standard being revoked and import duties being levied, along with the oil embargo being imposed by OPEC. All these events turned out to be far too complicated and catastrophic for the United States, as the economy saw uneven expansions and recessions and ultimately went into a stagflationary state. That particular period in the US was a topsy-turvy one, and the only word that could define the nation's economy was sporadic and maybe desultory at times. Even the Fed Funds Rate went from 3.7% in early 1972 to almost 13% in mid-1974 and then went down to 5%, before rising again in 1977-78. The inflation levels were exorbitant during these times as the average inflation during 1973-1979 was close to 8.5% yearly. The inflation levels kept rising following the second energy crisis in the wake of the Iranian revolution, and the interest rates reached an all-time high of 19% at the start of 1981. The 1980s' was a much better expansionary phase for the United States as the inflation levels were under control and even the energy prices stabilized, with the oil prices declining dramatically. Another exciting phase was the period of 1983-1985, which had relatively lower inflation levels ranging from 2.5-4.2%. However, the interest rates were not as stable as they started at 8.5% at the beginning of 1983, rose in 1984 to nearly 12%, and then again came down to lower than 8%. The rates were around 7.5-8% in the middle of 1978, but the inflation levels kept surging, much different from what was happening now. The main idea is that it was not only the interest rate levels that were moving the economy, but other factors such as low energy prices, the change in the costs of rentals and mortgages, and the rise in private investment also played a significant part. This event notably showed that the Fed Funds Rate is not imperative when controlling inflation but plays a psychological role in the economy. Between mid-1980 and mid-1981 saw an inflation level of close to 13% over 12 months while the Funds Rate was still high for some time. Another example can be the period from late 1984 to late 1986 when the interest rates went down from 11.5% to 6%. Still, the inflation levels kept decreasing, primarily because of what the US economy was coming off in the initial years of this decade. A lot of stimuli were created by the US government back then, backed by enormous debt but something that was effective and could reduce unemployment to a great extent. 

• Post-1990s: The late 1980s' and the 90s' was when inflation levels started to descend, and the interest rates were much lower. The United States began to rebuild in the 1980s' as the previous decade was an absolute disaster in managing the economy and implementing effective monetary and fiscal measures. Jobs started to come up, and although many jobs in the sectors of defence and construction were also erased, the net result was positive. This was when the interest rates were lowered, and growth solidified in the next 2-3 years, also giving rise to the dot-com bubble. The baffling part is that the inflation levels did not rise in the whole decade, despite the liquidity being at its peak and the rates reduced to their recent lows. Inflation rates remained within a range of 3-4% throughout. There could be a few reasons why the 1990s and the time since then have had low inflation levels and such low-interest rates. Now, the main drivers of interest rates are inflation and economic growth, and then the Federal Reserve might come in and try to tamper with the current rates in some capacity. In the 1990s', one of the most significant reasons for low-interest rates was the psychological, phrenic factor of the difference between expected and unexpected inflation. Throughout that decade, the expected inflation levels and the inflation targets set by the Reserve were higher than the actual levels. What causes demand shocks and rampage is unexpected inflation, not expected inflation. The exact reason for overestimating the predicted inflation levels is unknown. Still, the possible explanation tends to be around the specific calculation methods used to evaluate the expected levels. The calculations may have been made on a cost view of inflation, using Phillip's Curve as a reference. Using the unemployment and inflation levels and basing the assumptions on that would not have worked as the natural unemployment rate was shifting and consistently lowering over time. The main reason for the lower inflation levels was primarily a structural one. Technically, the Federal Reserve hardly had any role in maintaining/influencing inflation or the interest rates. The structural shift was due to the increase in the labour supply due to increased immigration, which increased the overall productivity and supply and the aggregate demand for goods and services. The global economies also opened up in this decade and aided in the overall increase of productivity, strengthening the economy's position and ensuring that the supply chain is balanced by importing goods and services to cater to excess demand. 

How unemployment and inflation rates have moved together in the last 50 years shows that the relationship has changed. The 1970s and 80s saw a divergence in the unemployment and inflation rates, which might or might not imply a clear inverse relationship, but the rates started to converge around 1990. This indicates how the economy's structure has changed, and the unemployment rates and wages have become sticky. This also meant that the economy's unemployment rates and inflation levels would no longer be in an inverse relationship, and the hypothesis has changed since then.

THE INTEREST RATES CONUNDRUM

The graphs above show the movement of Nominal Interest Rates (Inflation Rate + Real GDP Growth) and the Fed Funds Rate, with the black column signifying the residuals (Nominal Interest Rates - Fed Funds Rate). Nominal Interest Rates are based on the Fisher Equation, implying that the intrinsic interest rates in the economy are a sum of the natural growth and the inflation levels. The rationale behind studying this relationship is to understand how different the Intrinsic Rates are compared to the Fed Funds Rate. In my opinion, the notion of the Federal Reserve setting and determining the interest rates in an economy can be refuted, but the Reserve undoubtedly creates an impact. The correlation between the Fed Funds Rate and the inflation level is significantly high at 0.77, with an R-Square of 60% (Movement accounted for). The correlation between the Fed Funds Rate and the Nominal Interest Rate is also very high at 0.74, giving an R-Square of 54.5%. Now, the causality of these rates cannot be proven through this. Still, it is clear that since the Reserve usually sets its overnight rate based on the inflation levels and since the Nominal Interest Rates consist of inflation levels, it can be hypothesized that the Federal Reserve follows inflation and Intrinsic Rates instead of changing them. In the graph, you can also see the lagging nature of the Fed Funds Rate, and that is the reason why out of the last 49 years, the residual has been positive (A case when the Intrinsic Rates are higher/lower than the Fed Funds Rate, given that both are moving in the same direction). Intense domination of positive residuals and a highly positive correlation show that the Federal Reserve is a follower of trends and the underlying metrics.

A conundrum arises when determining the correlation between accurate growth rates and inflation levels. It is widely accepted that the increase in the Real GDP gives rise to higher inflation levels, but it does not seem like that. The correlation between real growth and inflation came out to be -0.12 in 1970, which dismisses the idea of these rates being related. Although, the correlation level has been positive since 1990 and goes up to 0.4 when the last 20 years are looked into. However, this is not significant enough to establish a core relation between the intrinsic interest rates and the inflation rate. Similar to this, the correlation level between the Fed Funds Rate and the real GDP growth has also been low, indicating a possibility of the Federal Reserve having limited power to influence actual development. Given all of this and how I have perceived this information, I can state a few things I am confident about. First, the Federal Reserve does not influence the real growth or the prevailing interest rates in the economy and is a trend follower, not a setter. Secondly, it cannot be determined whether real change gives rise to inflation.

CONCLUSION

In conclusion, my opinion and hypothesis indicate a pattern related to how interest rates can move in an economy. In absolute honesty, it is difficult to believe why people think the Reserve is the driver of every single strand of change out there. The monetary policies are essential and can make or break the economy, but the whole perception of manipulating interest rates seems a bit overblown. Regarding interest rates, the Federal Reserve never sets the pace and can only influence it indirectly through prime rates and a cluster of population reacting to it fearfully. Interest rates are driven innately and tend to be based on the expected real growth and inflation. Whenever there is unexpected inflation, the intrinsic interest rates tend to rise, followed by the actions of the Federal Reserve.

Another crucial point that should be made clear is that of changing structures of economies and the impacts it can have over the long run. Economies worsen and improve over time, but often, some changes shift the paradigm concerning the functioning of a country. This happened in the US in the early 1990s. It might happen again, considering the higher debt levels, rising energy prices, and the unnecessary steps taken by the US to deglobalize itself. Higher interest rates might become the norm, or they can be transitory as some people have made them. Albeit, one thing is clear: the overreaction we see as to the possibility of a recession and the pertinent question as to why the interest rates are rising, given that the inflation seems strictly pushed by increasing costs and not based on higher levels of demand? There is a high possibility of the Federal Reserve further increasing its rates this month. Although the expected rise is supposed to be 1%, I believe it could be slightly less to avoid any ulterior market shocks, probably around 0.5-0.75%, and another 0.5% over the next couple of months. Without stating that these rates are of utmost importance, it triggers a set of reactions, and it's better if the responses can be contained in the form of a slight increase, not a cumbersome one. It hardly makes a difference whether the growth is by 0.5% or 1%, but since the perceived power of these rates is right up there, it would be better to keep it under the expected rate. Dr. Michael Burry warned us about the Bullwhip effect, and it makes a lot of sense, considering how the Federal Reserve is making it expensive to borrow money, despite the demand levels being at a specific limit and knowing that disrupted supply chains can be even more disrupted following the sudden shift of liquidity in the general markets. The question remains to be answered, and the answer will further give rise to several questions.