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Counter-Intuitive Inflation – Introduction

This is an excerpt from Counter-Intuitive Inflation. We’ll be posting sections over the first two weeks of October.

Introduction:

During inflationary times, and especially when we have high employment and growing GDP, the Federal Reserve raises interest rates to reduce inflation. Raising interest rates is a crude tool, but historically, an effective one. Now, some economists and market commentators are suggesting that the same rate hikes the Fed uses to reduce inflation could also create more inflation. While counter-intuitive, I believe this argument is correct. Let’s go over the idea and why I believe it’s different this time.

This round of inflation was caused by massive Congressional overspending combined with a decade and a half of near-zero interest rates and countless rounds of quantitative easing (currency creation). This is a bipartisan problem. Neither political party has a working understanding of economics nor a plan to get overspending under control. Both parties deserve blame. However, the scope of this paper is to discuss economics, not to take a side in D vs R fighting.

 

How Fed Rate Hikes Reduce Inflation – Classic Model:

Think of interest rates as the price of money and time. Then, remember the old economics maxim that the higher the price of something, the less demand there will be, and the lower the price of something, the more demand will follow. (Luxury items like wine, watches, and handbags are the exceptions.)

When the price of money goes up with higher interest rates, the hurdle rate for new investments and projects rises. This discourages incremental capital expenditures and reduces demand for equipment. Higher interest rates lead to higher mortgage rates. This makes housing more expensive and reduces demand for lumber, appliances, and other building materials. Higher interest rates raise the cost of pulling consumption forward either due to foregone interest income, or through higher credit card rates. All of this works to reduce demand which in turn, reduces pricing pressure throughout the economy.

 

Information contained in this report is believed by Deep Knowledge Investing (“DKI”) to be accurate and/or derived from sources which it believes to be reliable; however, such information is presented without warranty of any kind, whether express or implied and DKI makes no representation as to the completeness, timeliness or accuracy of the information contained therein or with regard to the results to be obtained from its use.  The provision of the information contained in the Services shall not be deemed to obligate DKI to provide updated or similar information in the future except to the extent it may be required to do so. 

 

The information we provide is publicly available; our reports are neither an offer nor a solicitation to buy or sell securities. All expressions of opinion are precisely that and are subject to change. DKI, affiliates of DKI or its principal or others associated with DKI may have, take or sell positions in securities of companies about which we write. 

 

Our opinions are not advice that investment in a company’s securities is suitable for any particular investor. Each investor should consult with and rely on his or its own investigation, due diligence and the recommendations of investment professionals whom the investor has engaged for that purpose. 

 

In no event shall DKI be liable for any costs, liabilities, losses, expenses (including, but not limited to, attorneys’ fees), damages of any kind, including direct, indirect, punitive, incidental, special or consequential damages, or for any trading losses arising from or attributable to the use of this report. 

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