Will inflation cause a burst of the financial market bubble or a slow slowdown? | by Bruce H. Cottman, Ph.D. | February 2022

The annual inflation rate, as measured by the Consumer Price Index (CPI), increased in the United States to reach 7% in December 2021.

Figure 1. CPI inflation (%) by month for calendar year 2021. Source: US Bureau of Labor Statistics data.

Creating money to slow inflation is like pouring gasoline on a fire to put it out.

The Fed is proposing to use its other primary method. The Fed is planning a staggered sequence of discount rate hikes. The table below shows the average and standard deviation of the September and December Fed Chief forecast discount rates for 2022 and 2023.

Table 1. Source: Data from Federal Reserve press releases, table by author.

If we think of the standard deviation (STD) as the diversity of opinion among the 17 governors and one president, then the forecast Fed discount lending rate for 2022 and 2023 has increased, and its diversity has increased as inflation rose from 4.5% in September 2022 to 7% in December 2022.

Past Fed Rate Hike

The Fed raised the bank interest rate, often called a rate hike, to reduce inflation during the period beginning in April 2005 and beginning in January 2017.

From 2005 to today, the Fed has raised the discount interest rate twice. In both periods, the US financial market fell 15% or more.

The predominant reasoning for the market downturn is that debt is getting more expensive. There are probably more factors that caused the downturn in the financial market.

Figure 2: Covers the period from January 2005 to December 2021. Green boxes cover periods of Fed rate hikes and inflation, as measured by the CPI, above 3%. The red boxes cover periods of decline or stability in the Fed rate and inflation, as measured by the CPI, above 3%. Source: Author’s graph, data from the US Federal Reserve and Bureau of Labor Statistics and Yahoo.com.

To note: The behavior of the CPI, Fed Discount Rate, and the NASDAQ Index is shown in Figure 2. Little to no diagnostics of the behavior of the CPI, Fed Discount Rate, and of the NASDAQ index is advanced.

Above, in Figure 2, I have numbered the major trends for the CPI (inflation), the Fed rate, and the NASDAQ index.

  • The numbered blue squares, 1 to 5, indicate when the CPI is approaching or exceeding 3%.
  • The numbered red squares, from 1 to 7, indicate the bottom or bottom of the NASDAQ stock market index.
  • Numbered gray squares, 1 through 5, indicate when the Fed’s rebate has been stable for two quarters, six months, or longer.

The Fed rate has been raised twice since 2005. Both times the NASDAQ fell.

Old Fed Rate Setting Policy

Fed policy has varied from 2005 to present as the president, governors, and economic sentiment have varied.

Figure 3: Covers the period from January 2005 to December 2021. The number following the dash in the label corresponds to the type of Fed rate action. FedRateRaise is triple counted due to expected rate hikes in 2022 and 2023. Source: Author’s chart, Federal Reserve and US Bureau of Labor Statistics data.

I’m trying to simplify the complex and changing Fed rate-changing actions shown in Figure 3.

  1. The Fed rate is raised if the CPI has been above 3% for at least two quarters AND the financial market is NOT falling.

The exception is that the CPI has been above 3% since April 2021 and the Fed has yet to raise rates. However, the Fed’s body of 18 governors predicts that they will raise the Fed’s discount rate.

The Fed’s expected average rate for 2022 and 2023, as shown in Table 1, increased from the September 2021 meeting and increased significantly more at the December 2021 meeting.

Inflation continues to rise in January 2022. Shortages caused by several issues in the supply chain, historically high inflation, corporate earnings, variants of the COVID-19 pandemic and a tangle of growing geopolitics are causing stronger, not weaker, headwinds in financial markets.

2. The Fed rate is lowered or kept low, even if the CPI has risen above 3% if the financial market is down or not down.

Remember the apparent exception to policy #1 above, where the Fed rate hasn’t been raised even though the CPI has been above 3% since April 2021?

The NASDAQ began to decline, turning in late December 2021. But the Fed’s rate forecast has risen since the September 2021 meeting. Has the Fed’s rate-setting policy changed?

Current Fed rate change actions (none) indicate that policy has not changed. The current Fed forecast for 2022 and 2023 and if the financial market continues to decline, then the historical behavior of the Fed has changed.

Has the Fed rate been raised for the third time since 2005, coinciding with another drop in the NASDAQ?

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