Decoding the New Economic Order: How the Relationship Between Interest Rates, Employment, and Inflation is Transforming

Just as the sun sets to give way to the night, the U.S. headline CPI inflation, after its splendid ascent, has taken a remarkable u-turn. It feels like we are on the road to reliving the golden era of persistently low inflation. However, analyzing the current trends and their drivers indicates otherwise. This shift in inflation dynamics, and what it means for us in the real economy, forms the crux of our analysis today.

The noteworthy decline in headline inflation can be primarily attributed to the elimination of factors that led to the price surge. As Will Rogers once famously noted, “if you want to get out of a hole, stop digging.” The COVID-19 pandemic led to a devastating loss of jobs for approximately 22 million U.S. workers. To soften the impact, U.S. policymakers initiated a staggering $5 trillion of government spending, backed by an equal amount of Federal Reserve purchases of Treasuries and mortgages.

However, this massive spending surge brought its own set of complications, like supply chain disruptions, which aggravated inflation further. As the reality of the inflation problem became clear and the pandemic started to wane, no further government stimulus was provided, the Fed initiated rate hikes and began shrinking its balance sheet, and the supply chain disruptions gradually eased. The end result – a rapid descent in headline inflation.

Yet, core inflation is an altogether different ball game. It continues to be robust due to the 8% rise in the shelter component of the price index, which holds about 40% weight in the index. The calculation of shelter prices, based on the convoluted homeowner equivalent rent, is at the heart of the problem. Nevertheless, there is an observed moderation in rental housing inflation, which is currently around 0.5% per month or a 6% annual rate.

Hedging Makes All the Difference

A point of contention has been why higher interest rates have not caused a significant increase in unemployment or recession. The relationship between rates, jobs, and inflation has dramatically evolved over the decades. In the 1950s and 1960s, the U.S. economy was mainly manufacturing and housing-centric. Financial institutions primarily relied on a model of borrowing short-term money and lending longer-term for housing or automobiles. The interest-rate risk in this model was colossal and not easily hedged, hence when rates increased, the economy floundered.

However, the economy today is largely service-based. Home mortgages are created and then sold to entities or funds willing to hold them. With the help of interest rate derivatives such as swaps, futures, and options, which were non-existent until the 1970s, interest-rate risk is now efficiently managed. Today, taking on interest-rate risk is a choice, not a business necessity, resulting in an economy less susceptible to rate fluctuations. While rate hikes do affect the value of stocks, bonds, and houses, they no longer have a significant impact on the functioning of a real economy equipped with risk management tools. Therefore, the much-feared recession due to rising rates remains a distant threat.

The New Normal

The trajectory of future inflation is another critical element to ponder over. Understanding why inflation remained low in the 28 years before the pandemic is essential to contextualize this. Globalization, technology, and demographic trends played a significant role in maintaining low inflation, rather than interest rate policies.

However, these forces have evolved and are no longer the saviors they once were. As supply chains reconfigure for resilience, consumers bear the cost. New technologies like artificial intelligence are expected to be labor-saving and protect profit margins, rather than reduce prices. Demographic headwinds, due to a low birth rate and the retirement of baby boomers, are set to tighten the labor market further.

Given the trajectory of headline inflation, it appears the Fed could be nearing its peak rate. Yet, as guided by the Fed, rates may have to stay elevated for a more extended period than what is currently expected due to inflation persisting above their 2% target. Market participants who haven’t accounted for a potential new normal in inflation need to revisit their models. The implications of this are significant: allocating to cash may become a long-term, reliable income-producing alternative to manage risk in a diversified portfolio.

In summary, our understanding of the link between rates, jobs, and inflation has evolved significantly, as has the economy itself. As we continue to navigate these changes, it’s crucial to consider the “new normal” and the dynamics shaping it. This flexibility and understanding will be essential for both policymakers and individuals as we head towards an uncertain future.