Moneybeat - Inflation and interest rates

MARY REICHARD, HOST: Next up on The World and Everything in It: the Monday Moneybeat.

NICK EICHER, HOST: Time now for our regular conversation on business, markets, and the economy. Financial analyst and adviser David Bahnsen is here. Morning, David.

DAVID BAHNSEN, GUEST: Other than the Fed news—and we should certainly cover that—but outside of the quarter-point interest-rate rise the Federal Reserve has been telegraphing for months and finally did, would you say there was any big economic story of the week?

BAHNSEN: Oh, I guess, it was kind of a weird week economically, because there was a lot of focus on the Fed. And then it's the first week where I've wondered if the Russia-Ukraine story is starting to get kind of baked in as a long-term story, not one that like everyone is focused on day by day, there's a lot going on day by day, and it's a big story day by day. But I do think those first few weeks of the drama, now people are kind of like, okay, you know, this is gonna go on a little while. But also, I think this week, too, you did see something I've seen throughout my career and something that I do believe is very common. And that is that, supposedly, the markets are concerned about the Fed taking liquidity out of the economy, and worried about the Fed increasing the cost of capital - raising interest rates. They do exactly that, announce officially and act officially on what they've been sort of talking about for months and months, and the market rallies. And so just a very significant move higher in the markets on the news that people would think the market wouldn't like. That kind of contrarian reality is something that I think a lot of people will never get used to.

EICHER: Would you talk through the mechanics of the rate hike? When a listener reads about a Fed action like this, could you describe what the Fed actually does?

BAHNSEN: Well, when the Fed announces they're raising interest rates, they're only referring to what's called the federal funds rate. And it's a target. They're going to go do what they call open market operations - their buying and selling of securities to get to a certain rate, you're talking about an overnight rate and ultra short term rate. And when that rate’s at zero, they're basically trying to facilitate borrowing at the ultra short term, because there's no cost to doing so. And then when you raise rates, there's a small cost. And the, obviously, the higher you go, the more the cost is. So it is intended to be either incentive or disincentive for borrowing under the premise that borrowing is driving some form of economic activity. So that's kind of the mechanics of it, Nick. And I think that this is really where the focus is right now is on the rate. And yet the other issue is what the Fed’s going to do about their balance sheet, as they bought $3.9 trillion of treasuries and mortgage bonds during COVID. And now they have to somehow try to get those things off of their balance sheet, without causing big problems in the market, in the economy, in borrowing and other things like that. So they have a lot of work ahead of them.

EICHER: Okay and the stories we’re all reading in the financial press and in the regular press, all this work the Fed has in front of it, this is targeted, we are told, at taming inflation. How is what the Fed is doing going to fight inflation?

BAHNSEN: Well, of course, the idea is that by taking liquidity out of the financial system, that would be anti inflationary. And when you're putting liquidity in the system, the belief is that it's potentially more inflationary. Now, look, if the Fed really believed that they needed to take big monetary measures to stop inflation, do you think they would have raised rates only a quarter of a point? It'd be hard to imagine a smaller measure. You know, it'd be like if someone says I desperately need to lose a lot of weight. I'm going to go down from eight cheeseburgers a day to seven and a half cheeseburgers a day or something. I mean, obviously, it isn't a very substantive move.

The reason in my opinion is that the Fed has to posture publicly that they're doing something to counter inflation - and the inflation that we have right now is actually outside the monetary category and much more related to the supply side. If the Fed did raise rates 100 basis points meaning 1%, instead of only a quarter point, they still could not possibly help China export more semiconductors or or more truck drivers go to work or more ports open up, and all these types of supply-oriented things are not really remotely related to the monetary side. But my view is, at the end of the day, they lose their emergency measure. That is because the Fed has been there to take huge measures when we have big problems, if they're already at zero, they can't do anything. And so they need to get back to something more normal, because something else in the future will happen and they won't be prepared for it. And yet they somehow now want to thread a needle of doing so without doing great damage along the way. And what I'll say just to give people historical context is there is no history. This is all basically, totally unprecedented. Japan went to many, many years of zero interest rate, all kinds of quantitative easing, they've never gotten off of it. They're still on it now. Our country did after the financial crisis - we started to try to get off it a little bit in 2018. And then they chickened out in early ‘19 and stopped and started cutting rates again. And then COVID came in 2020. So we, right now, we're not just dealing with COVID monetary policy. We're dealing with the monetary policy measures from the financial crisis that we never normalized. So it's experimental.

EICHER: All right, David Bahnsen, financial analyst and advisor, head of the financial planning firm The Bahnsen Group

You can catch David’s daily writing at DividendCafe.com. Sign up there for his daily email newsletter on markets and the economy. David, thanks again!

BAHNSEN: Thanks so much, Nick.

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