Your Economics Teacher Gaslighted You, and Why Inflation Keeps Increasing

October 2022 - The U.S. economy is in a recession: two consecutive quarters of declining GDP are all that is required.

In a recession, we typically see a decline in interest rates and inflation rates. Ironically, we are seeing the exact opposite:

• August 2022, inflation: 8.30%, from 1.30% two years ago

• September 2022, 30-year mortgage: 7.00%, from 3.00% two years ago

• September 2022, 10-year treasury: 3.80%, from 0.75% two years ago

If you’re confused about why America and the rest of the world is in such a flux right now, you’re not alone. We can’t merely blame Covid, Russia, or China either. While there is some part to be played by globally impactful events, there is another key reason that America seems to be flipped over on her head.

Inflation as of August 2022

How the Economy Works: 101

The economy cycles from expansion to contraction. Think of this like state changes over time that range from very good to very bad. Not all expansions are exuberant and not all contractions are painful. The year 2022 is one of those notable contractions that is very painful.

During expansion:

During expansion, things are great! You don’t hear many complaints from your neighbor, and everyone seems to be winning on all fronts: employment is high, housing markets are extremely competitive, stock markets seem to give free money, and startups grow like weeds.

Generally speaking, in expansionary economies:

• Businesses grow - because there is money for the taking

• Interest rates rise - because corporations are demanding more investment dollars

• Jobs are created - because corporations need more labor

• Spending rises - because people have more money

• Inflation rises - because demand for goods and services increases

During contraction:

We all know that people tend to go too far and then overcorrect, so it goes without saying that all expansions come to an end in some fashion. During a contraction, consumer spending growth slows and consumer savings start to rise as interest rates become more attractive. As a corollary, production falters as demand for products declines.

Contractions are easy to spot — when you start to hear stories on the news about people losing their jobs and not being able to buy their kids tons of Christmas presents, you’re in a contraction.

Generally speaking, in contractionary economies:

• Businesses decline- because there aren’t enough additional profits to justify expenditures

• Interest rates fall - because corporations aren’t demanding dollars to grow

• Jobs are lost - because companies don’t need the extra labor anymore

• Spending declines - because people have less money

• Inflation falls - because demand for goods and services decreases

Why interest rates fall during contraction:

In a free market economy, interest rates should fall when corporations are becoming more hesitant to borrow (i.e. sell bonds) due to a glut of either inventory or labor or both. As a corporation’s desire to borrow decreases, so does the interest rate they’re willing to pay to do so. This interest rate lowering affect usually begins at the peak of an expansionary period and signals a contraction on the horizon.

Did Your Economics Teacher Gaslight You?

While we can say that America is in a recession from a technical definition, does it really feel that way? There is only a slight increase in unemployment (left graph below) and the number of workers is still growing (right graph below). We are starting to see some layoffs and hiring freezes, notably at certain big tech firms such as Facebook; yet, decent jobs can still be found with reasonable effort.

According to theory, a contracting economy brings job losses, declines in spending, declines in interest rates, and declines in inflation. But as of October 2022, we’re seeing increasing interest and inflation rates paired with a stalled out, or arguably declining, economy.

So is economic theory just a pack of lies your former teacher told you to sound smart, or is there any hint of truth to it? To understand why increasing interest and inflation rates can coexist in a stagnant economy, let’s take a hard look at the most powerful market manipulator of the 21st century: the Federal Reserve Board.

The Federal Reserve Board is Killing Your 401(k)

From 2008-2021, the Federal Reserve Board (the FED) has been working in conjunction with the United States Treasury to increase the money supply, a process called quantitative easing (QE). During QE, the Federal Reserve Board purchases government bonds from banks. This has a stimulatory effect on the economy because it increases the banks’ reserves and therefore makes it easier for those banks to lend at more favorable terms, resulting in the growth and expansion of American businesses. While QE is useful to stimulate an otherwise declining or stagnant economy, it is a powerful tool that flies in the face of a free market economy.

Money supply in America

During QE:

• The FED is lending to the economy - this is stimulatory

• Stock prices rise - because businesses can grow so much more when money is cheap

• Bond prices rise - because the FED adds to bond demand

• Interest rates fall - because the FED is such a willing lender, the banks can pay lower interest rates

By manipulating interest rates to artificially low levels, the FED never allowed the U.S. to recover organically from the 2008 market crash. The FED essentially propped up American businesses with free money, so the true market rate of interest could not be found. It has done this over and over again from 2008 to 2022. In March of 2020, for example, the FED increased its asset purchases by $1.50 trillion and then added another $500 billion four days later.

The good part about QE is that it allows the economy to grow and expand to levels it otherwise couldn’t, much like an athlete taking anabolic steroids. However, the downside is that inflation will eventually run rampant because people have too much money to spend. The FED had historically navigated the inflation issue well and kept it stable from 2008-2021. But it’s very tenable that the downstream effects of Covid lockdowns were the straw that broke the camel’s back.

Now, in 2022, the FED has removed its support of the QE program to thwart inflation. It is instead selling government bonds back to banks, a process called quantitative tightening (QT). In QT, interest rates rise because the FED is flooding the market with a newfound demand for dollars. QT increases interest rates and simultaneously pulls money out of the system. The idea here is that by increasing interest rates via QT, stock markets will crash, home prices will fall, and eventually people will stop spending money; inflation should decrease as a corrolary.

During QT:

• The FED is borrowing from the economy - this is dampening

• Stock prices fall - because businesses can’t grow as quickly when money is in short supply

• Bond prices fall - because the FED is selling off the government bonds it previously purchased

• Interest rates rise - because the FED is such a willing borrower, the banks can charge higher interest rates

What about Inflation?

The strange part about all this, again, is that expansions should bring about rising inflation, which should naturally bring about higher interest rates until, at some point, the contractionary cycle should begin. But because the FED has been laying on the economic gas pedal in the form of QE for so long, interest and inflation rates are rising in the face of the 2022 economic slowdown, which creates an even more harmful contraction.

It’s worthy to note that this contractionary cycle was inevitable; it was a always a question of “when” not “if.”

Think of the economy like a pendulum. If you swing too far in the direction of QE, the pain of QT is going to feel even worse.

What Next?

It’s very likely that America is in for a bit more economic trouble over these next couple of years as QT runs its course. But trying to guess what the FED will do next is a fool’s errand; therefore, it’s still a good idea to stay long-term oriented with your financial plans and investment portfolio.

At some unknown point, the process of QE will likely begin again, creating another spectacular growth period in America. Or, perhaps the Federal Reserve Board will learn its lesson and retire the QE program altogether, letting the free market decide the appropriate interest rates to pay.

Only the future will tell, and it’s very uncertain.