The Federal Reserve should be objective…
After all, the U.S. central bank focuses on numbers. And numbers are as objective as it gets.
But for some reason, the Fed isn’t sticking to the numbers in its quest to cure our current inflation woes. Instead, it keeps doing what it thinks will work… without actually knowing if it’s working.
And in the end, individual investors like us will suffer because of this willy-nilly approach.
Let me explain…
Put simply, the Fed ignores the idea of a “response lag.”
Specifically, I’m talking about how changes in the inflation numbers lag behind the Fed’s adjustments to interest rates.
Despite what the Fed and the mainstream media want you to think, raising rates doesn’t lower inflation immediately. Instead, the market lags behind the changes the Fed makes…
As you likely know, inflation is when every dollar is worth less than it used to be.
And when the Fed raises interest rates, it seeks to make every dollar worth more than it used to be. It tries to do that by decreasing the amount of money in supply.
The Fed attempts to decrease the money supply by making it more expensive for businesses to borrow money (so they don’t borrow and add to the supply). With higher rates, the Fed also increases the return that money earns when it sits in the bank in savings accounts (hoping people will decide to save the money instead of spend it).
But there’s a problem…
A gap exists between the time when the Fed raises the benchmark rate and when people and businesses decide to spend that money or not (especially businesses).
You see, businesses don’t undertake new expensive projects every day. And people don’t decide to buy new expensive appliances every day, either.
As a result, inflation can’t come down immediately. A lag exists.
Now, it’s hard to quantify the length of the lag. Not many research papers – if any – study the lag effect.
But it’s pretty clear the lag is greater than the one-month period between the Fed’s meetings.
Think about it… the Fed has raised the benchmark rate four times since March. And yet, inflation hasn’t significantly decreased yet. In fact, it kept going higher until this past month.
The lag is commonly believed to last anywhere from a year to 18 months. In other words… the Fed’s rate hikes over the past few months might not change anything for at least a year.
Now, it might not take that long for inflation to come down to more normal levels. But my point is simply that a lag exists. And it’s longer than the Fed’s one-month rate-hiking schedule.
And yet, Fed officials don’t talk about the lag. They just keep raising rates without seeing if it’s actually working.
That’s how recessions are born – and made worse. Eight out of the past nine times the Fed raised the benchmark rate, it threw the economy into a recession.
The bottom line is… the Fed isn’t focusing on the numbers or the data.
It’s playing into the panic of rising inflation and blindly hiking the benchmark rate to battle inflation. It’s trying to make it look like it’s doing something… anything.
And with a recession upon us, that approach will only hurt investors like you and me.