The U.S. Interest Rate Problem Just Got Worse

There's a lot of debate about the past three years of high inflation and that impact on American families. And now that inflation is receding, there's been a great deal of speculation about when the FED would cut rates. What say you?

So, uh, what we said is that the committee would like to see more data that confirm and make us more confident that inflation is moving sustainably down to 2%.

Alright team, welcome back to Macro Watch with Brandon. I don't like going here too often, as you guys know. For my style of investing, I pretty much completely block out all macroeconomics. But I wanted to make this video because there are a lot of people out there banking on the idea of imminent interest rate declines. I really feel the need to just put out the evidence here in its own dedicated video and really discuss what on Earth is likely to happen with interest rates over the course of the year.

So we've got a lot to talk about in this video, but the story starts with inflation. Headline inflation has moved down more than three full percentage points now to 2.4%. As I mentioned in my remarks, we want to see a little bit more data so that we can become confident and so that we can take that step of beginning to reduce policy rates.

If you don't know who this guy is, here is Jerome Powell, who is the chair of the Federal Open Market Committee—a group of people who sit down every 6 weeks or so and collectively decide what to do with U.S. interest rates. They have their hands on the economic lever, and they get to decide whether they push, pull, or just leave it alone.

Now, this interest rate, known as the federal funds rate, has a flowing effect into the broader economy. If interest rates go up, variable rate mortgages get more expensive. New fixed rate mortgages will face a higher interest rate. Businesses looking to get loans will face higher borrowing costs. Generally speaking, it makes the cost of borrowing money more expensive. It puts the brakes on the economy. It can cause businesses to have to pull back; it can cause higher unemployment. It makes the economy slow down. But why would you want to slow down the economy?

Well, generally speaking, of course you don't. You want a thriving economy. But sometimes, when the economy thrives a little bit too hard, when people are doing a little bit too well, this causes prices to rise. Businesses see that they can start charging more for their goods and services. Workers want more money for the same amount of effort. People can take on bigger loans and put that money into property or shares. The economic boom time leads to inflation, and that's exactly what happened in the United States during COVID. Interest rates would drop to zero and a lot of money was printed and handed out to citizens and businesses.

Now, I'm not here to get at all political about the topic, but the harsh reality was that despite this money printing providing temporary economic relief—well, it was temporary. The can was kicked down the road, and now we're effectively dealing with the economic crisis we should have had in 2020 and 2021. And the way we're dealing with it is through this inflation.

Inflation was actually extremely low before the pandemic. Over 2021 and the first half of 2022, it skyrocketed up to a staggering high of 9.1% in the U.S. Now, the Federal Reserve's target is an inflation rate of 2%, a heck of a lot lower than 9%. So what this meant is that the FED needed to put the brakes on the economy. They needed to push that lever and raise interest rates from zero to 5.25 to 5.5% in order to cool the U.S. economy. And it largely worked.

Have a look at this chart that plots both inflation and interest rates. The results are clear. The FED raised interest rates, and inflation came back down. But it's still not where it needs to be. We’re in a precarious position now where inflation has cooled, but it isn’t quite low enough to take the clamps off the economy.

Because look at this: This is the fresh inflation data that was recently released by the Bureau of Labor Statistics. Firstly, the headline rate was 3.2%, which doesn't seem that high, but remember it is over 50% higher than the FED's target inflation rate, and it appears to be pretty sticky.

If we have a look at the last 5 years of inflation, we can see a tremendous decline in inflation in the second half of 2022 and the first half of 2023. But since the middle of last year, inflation has not made significant downward progress. It's been hovering, almost waiting for the Federal Reserve's next move. But honestly, it's not even headline inflation that's the most frustrating data point right now.

There are two others: core inflation and month-over-month inflation. Firstly, if we look at price changes versus the prior month, we can see that last year inflation was headed in the right direction. We had 0.5% month over month in August, then 0.4% month over month in September, then 0.1% in October. So things were looking good.

But have a look at what happened since then: 0.2, 0.2, 0.3, and now in February, 0.4% on a seasonally adjusted basis. From October last year to February this year, we've seen each month starting to get a little bit worse again, and that's not a good trend. It’s definitely not what the Federal Reserve wants to see.

Then from there, the second number that we have to look at is what's called core inflation, which is simply the Consumer Price Index excluding food and energy. The reason they do this is because typically food and energy prices can fluctuate a lot in the short term, which makes the true underlying inflation number difficult to read. So they get rid of these categories for this particular metric.

When we look at core inflation, things are actually a little bit worse. Headline inflation is currently 3.2% in the U.S., but core inflation is significantly higher at 3.8%, and it's really hovered around that 4% range since October last year. Furthermore, if you look at the month-over-month data again for core inflation, it's actually been trending up since the middle of last year.

So I don't want to be a Debbie Downer, but I do want to highlight the situation as it stands today. The FED has said that they will look to lower interest rates at some point this year; that is correct. But they have also been very clear that they need to see further data showing that inflation is trending down towards their long-term goal of 2%, and right now that is not happening.

Raising interest rates did get on top of inflation, but it has started to stabilize at a level that is still too high. Unless the inflation data starts to reverse the trend of the last few months, we cannot expect the FED to do anything except hold interest rates steady or even raise them further. The main reason for this, as I've said in many videos now, is because of what happened in the 1970s. That was the worst period of inflation the U.S. has ever seen, and most of it was down to bad monetary policy decisions.

I've shown you this chart before, but have a look at inflation in the 1970s with the FED funds rates superimposed on top. Inflation went up; the FED raised interest rates; inflation came back down, but not quite back to where it was. The FED loosened interest rates a bit early, and look what happened: Inflation spiked again. But here's the crazy thing—they made the same mistake again. Interest rates went up as inflation skyrocketed, inflation started to cool once again, and interest rates were lowered. But for a second time, the FED released their grip too soon, and again inflation ran up.

In fact, the third bout of inflation was the worst, and it took a guy called Paul Volcker to come in and raise interest rates to a punishing 20% to try and finally curb inflation once and for all. History shows that is what happens when the Federal Reserve releases its grip on inflation too early, and it is what the FOMC are acutely aware of this time around. Jerome brings this up in every second press conference he does. They do not want a repeat of the 1970s.

So I know that the Federal Reserve has said they are looking to lower interest rates, but I really don't think we should expect this in current conditions. At the end of the day, they will want to be super conservative, and at the current time, the inflation data is not trending the way they want it to go. No doubt that will make some people sad, but despite the media exciting us with stories about interest rate cuts, the economic reality just doesn't point to that happening anytime soon.

Jerome Powell has been very clear on this: Inflation is still too high. Ongoing progress in bringing it down is not assured, and the path forward is uncertain. We want to see a little bit more data so that we can become confident and so that we can take that step of beginning to reduce policy rates. You know, we want to see more evidence that inflation is moving sustainably down to 2%.

The lower inflation readings over the second half of last year are welcome, but we will need to see continuing evidence to build confidence that inflation is moving down sustainably toward our goal. We have some confidence in that; our confidence is rising. We just want some more confidence before we take that very important step of beginning to cut interest rates.

There's no shortage of clips of Jerome Powell being rather clear, right? So I just want to caution everyone that's getting a bit excited about the idea of interest rates coming down immediately and monetary policy returning to the way it was before the pandemic. We are a long way away from that world.

I also wanted to caution against getting fooled by the wording the Federal Reserve uses because it is true they've said they will lower interest rates throughout 2024. It's true they said they'll likely do it three times. But what does that actually mean? Well, unfortunately, it doesn't mean much.

Remember, the Federal Reserve usually moves interest rates 0.25% at a time. Now, we're currently at a federal funds rate of 5.25 to 5.52%. So even if they do decide to drop rates three times in 2024, it likely leaves us with an interest rate between 4.2% and 4.75%. So while that may take the edge off, it gets us nowhere near the cushy environment we got so used to prior to the pandemic, and that is not coming back for a very long time.

So, I know a lot of you guys are well aware of this, but maybe if you know someone who is expecting interest rates to drop a lot this year, please go ahead and send them this video. The only other thing I want to say is that while this video is based on the numbers that are coming out at the moment, there is one factor that may cause inconsistent behavior from the FED, and that is quite simply political pressure.

Now, I think the FOMC take their jobs very seriously, and Jerome has stated that they will not be considering the political landscape and the 2024 election at all in making their decisions, which is good, and it's definitely the right thing to do. But there is the possibility that pressure might get to them.

So really, definitely don't take anything I say as gospel; definitely do your own research. But my conclusion is certainly that I think the Federal Reserve should just leave things as they are and be very, very cautious if they're going to think about lowering interest rates. Because we definitely don't want any more repeats of the 1970s.

But anyway, that's it for today, guys. Thanks very much for watching. New Money Education is linked in the description if you want to learn how to invest properly and support the channel in the process. But apart from that, I will see you guys in the next video.