RIP 2% Inflation

Manufactured economies never end well.

I recently wrote to our paid subscribers about the manufactured economy that we’re all currently living in… I called it a “fake” economy. 

Real economies thrive by producing value. Fake or financial (i.e. manufactured) economies thrive on debt. 

Debt becomes more and more necessary when you can’t pay your bills with the resources that you have. Sometimes it’s a result of living far beyond your means. Other times it’s simply not being able to keep up with the cost of living.

Either way, debt becomes the answer.

And the greatest inducement to taking on more debt is cheap money.

A Generation of Cheap Money

Everyone likes cheap money. But cheap money is just that… cheap. It has no value of its own. Too much of it only inflates prices, diminishing purchasing power. It builds fake economies — and fake prosperity. 

And unfortunately for the past 22 years, since the Tech Wreck of 2000, cheap money has pretty much become the default expectation of just about everyone. But it’s a false belief. 

The whole idea of 0% interest rates and 3% mortgages is a fantasy. A fabrication of the fake economy to make you think that things are better than they are. 

Not so long ago, when banks were busy inflating the housing bubble, between 2004 and 2007, 30-year mortgage rates traded between 5.4% and 6.8%!  Current expectations that 3% mortgages are somehow normal is nuts!

And it’s going to have to get corrected soon. Because a normalization of interest rates is the only thing that gets the current bout of inflation under control. 

We’ve Been Here Before (Sort of)

Right now we’re in the middle of a huge inflationary storm. I’ve covered the causes of the situation before… A crushed supply chain, too much stimulus, a presidential administration that’s hostile to the energy sector, a war in Eastern Europe…

Last month headline CPI ticked in at 9.1%. Screaming high — but not the highest we’ve ever seen. 

Back through the 70s and early 80s, inflation hit peaks of 12% and 15%. Over the course of the entire decade between 1973 and 1983 inflation averaged 9% every year!

9% a year!  For 10 years!

Think about that for a second…

But humans don’t like to remember bad times and a lot of people have forgotten what actually happened during that period.

As inflation began to rise, so did Interest rates. By 1980, when inflation was topping out at 14.8%, the Fed Funds rate was peaking at 22%. The 20-Year Treasury note was yielding over 15%. And 30-year mortgage rates were heading to over 18%!

Interest rates rose to crisis levels — high enough to actually break demand…

And over the years, these soaring interest rates forced the economy into not one, but three recessions in 1973-74, 1980, and 1981-82.

Recessions kill demand. And dying demand ultimately kills inflation. 

And that’s where we’re headed right now.

A New Financial World Order

The Fed really won’t be able to impact prices today by simply nudging rates higher. I’ve said this before, and it’s unfortunate, but it’s very likely going to take a recession — a knife in the heart of consumer demand — to bring prices down meaningfully.

How high rates go before inflation subsides is anyone’s guess. But in the aftermath, things are going to be different.

After all the ugliness is done, I’d expect the Fed to shift their 2% inflation target. They’ll find some excuse to redefine that target higher. Maybe as much as 3% or 3.5%. (Compared to 10%, that’ll probably be welcomed!)

At that point they’ll need to retarget the Fed Funds rate above that. I’d look for 4.5% to 5% (probably even higher).

Higher interest rates are not an aberration, they’re the norm. And a fact of life we’re going to have to get used to…

Make the trend your friend,

Bob Byrne
Editor, Streetlight Daily