Interest rates up…again?
Why are Central Banks still raising interest rates?
As explained in earlier blogs, monetary policies as a reaction to Covid, have caused massive inflation around the world. To fix this, Central Banks, including the Bank of Canada and the US Central Bank (FED), have been raising interest rates. This is usually done to slow credit, spending and economies. The problem is the speed and level of these hikes. To go in 12 month from 0-5 percent is an astonishing speed with severe consequences to the economies. In fact that is more severe than going from 10-20 percent in the late seventies. So, why are Central Banks still raising rates, risking severe economic pain?
Central Banks’ approach to fighting inflation is old and outdated, just like most of their members. This period will most likely go into history as a period where Central Banks tried to correct an earlier mistake with another mistake.
Central Banks holy grail to measure inflation is the CPI (Consumer Price Index) and then the Non-Farm Payroll (jobs in private sector and government agencies). While the CPI is relevant and has many important elements to it, economies around the world have changed and the CPI hasn’t adapted its basket accordingly. The biggest disadvantage of the CPI is that it has a significant lag, meaning when economic circumstances change, it will take months to show up in the CPI. The Non-Farm Payroll has the same issue, it relies on the Bureau of Labor Statistics collecting information and is therefore behind as well.
We are consistently going through a business cycle of Expansion and Contraction, Expansion-Contraction, Expansion-Contraction… There are better and more relevant indicators for anticipating when that switch occurs. For instance the national statistic of hours worked per week. When hours worked per week are down, it’s usually a sign of a near contraction and when hours worked per week are up, it’s a sign of a near expansion. Employment numbers will reflect that trend much later because they usually don’t change right away. When things slow down, employers will first cut hours, not people and when things pick up, they will ask their current employees first to work more hours before hiring more.
Central Banks are always behind in their approach and that has really been showing over the last two decades. They had no concerns about the US housing market, right up until it collapsed in 2008. Nobody is asking them to go and get a crystal ball, but their approach needs to turn into something more proactive. Our economies have changed and have become much more service oriented. The CPI doesn’t reflect that enough. The PPI (Producer Price Index) on the other hand does. While the CPI is still far away from the Central banks goal of 2%, the PPI is down from last year’s 11% to 2.3%. Inflation seems to be much lower than Central Banks admit.
We as consumers will feel the inflation pain much longer of course. There are places that benefit and they will ride this out as long as they can. It’s hard to say when our largest Grocers like Loblaws, Metro and Empire will stop robbing us blind. They have now become used to record profits, and pleasing shareholders going forward could be difficult without actual inflation increasing. But that is a different issue than the broader economy, and raising interest rates will not make grocery prices go down.
There are clear indicators that deflation has already started in the broader economy, but Central Banks stick to their stale Employment and CPI data and keep raising interest rates, which ironically could be already setting up their next failure. There is an ignorance here towards the fact that the labour market is already changing, most commodities have come down in price and the service sector including airfares, delivery services and Hotel/Motel prices have come down as well. While prices are still high, the trend shouldn’t be ignored. Having interest rates too high will cause damage. Let’s not forget that we are still a few months away from feeling the real pain of mortgage rates that more than doubled for many. Most of these mortgages have yet to go through renewal. My guess is that we may see the 40-year mortgage re-appear to avoid bigger damage.
What does it mean for the financial markets and investors? If you are a long-term investor, nothing really. If your time horizon is shorter because you don’t like the long-term approach and feel the need to change things every time you read a statement, the possibility of a near downturn has increased and you should make sure that your fixed income portion of your portfolio is intact. Many have abandoned bonds because of the disappointing returns last year but things have changed. If you are a trader, the VIX or S&P puts can be great hedging tools.
So far, markets seem to ignore the signs of a possible downturn, but a look under the hood reveals that this positivity is mostly fueled by just a handful companies and a little AI boom.
