At the risk of going to the inflation well one too many times, we are writing about inflation once again this week as we believe it remains – outside of the coronavirus – the topic of greatest concern among investors. It is also an incredibly important point of consideration for both the Federal Reserve, as our central bank looks to begin normalizing monetary policy, and for the political class in Washington, DC, as our nation’s leaders debate how much fiscal support is appropriate for an economy that is confronting meaningfully higher prices today, as supply chains remain snarled and millions of jobs go unfilled.
This week we look at inflation in relation to interest rates, specifically, the Fed Funds Rate, which we think is the Fed’s primary tool for trying to stimulate the economy (by cutting rates / keeping rates low) or slow the economy (by raising rates / keeping rates high). There is the absolute level of the Fed Funds Rate – which is 0% to 0.25% today, an incredibly stimulative level – and the Real Fed Funds Rate, which is the rate relative to the rate of inflation (if the Fed Funds Rate is less than the rate of inflation, the Real Fed Funds Rate is negative, and if it is above the rate of inflation the Real Fed Funds Rate is positive). Most students of economics believe the more negative the Real Fed Funds Rate, the better for economic growth. Consider, if the cost of capital is meaningfully below the rate of inflation, one is highly incented to borrow and purchase productive assets or invest in financial assets as it is likely either endeavor will prove profitable.
Today, the Real Fed Funds Rate is the most negative it has been in 40+ years (see chart), while prior to the pandemic-driven downturn, it had taken a Real Fed Funds Rate of positive 3%+ before the economy was at risk of recession (see chart). Even as the Fed looks to begin tapering its securities purchase program this month, and the odds that the Fed raises rates several times next year continue to increase, monetary policy is, and should remain, very supportive of economic growth and risk assets.
Tagged: Tim Holland, weekly wire, market perspectives, Fed Funds Rate, inflation