This week’s sell-off in the market has people wondering: is it really a good idea for the Federal Reserve to be increasing interest rates? Is President Donald Trump correct in his criticism of Federal Reserve governor Jerome Powell?
To answer that question, we need to understand the purpose of the Federal Reserve, specifically, its dual mandate. According to the Federal Reserve Act, its mandate is threefold. From the Federal Reserve’s website,
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
The above statement clearly identifies the goals of the Federal Reserve. The two most important for the sake of our conversation here, are the goals of,
- 1) MAXIMUM EMPLOYMENT, and
- 2) PRICE STABILITY.
Now hold that though, we will come back to it in a bit.
Federal Reserve independence (from politics), is a unique and sacred characteristic of the US central bank. Many other central banks around the world are plagued by political influence; the countries of those central banks have suffered as a result, as politicians have used the central bank to bribe the public, exchanging easy money for votes.
Some say President Donald Trump’s unprecedented criticism of the Federal Reserve is just that, an attempt to shame the Federal Reserve publicly. In today’s populist and polarized political environment, its a win-win for Trump: if the Fed stops raising rates, he wins. If the Fed doesn’t stop, he’s diverted any negative economic consequence away from the White House.
Turkey is a perfect example of what happens when monetary policy is used as a political tool. Turkey experienced a sharp jump in inflation recently because the central banks, at the coercion of Prime Minister Recep Tayyap Erdogran, kept interest rates too low, for too long. When interest rates are too low for too long, investors worry that money is being borrowed too easily. They also worry money is being borrowed to people who shouldn’t have loans.
Of course, the reason the Prime Minister did this was to keep voters happy, since anywhere in the world, voters will vote with their pocketbooks.
The reasons behind the inflation have to do with debt, and specifically, debt denominated in foreign currency. Turkey owes a total of $200 Billion of US Dollar debt, a gigantic number given the size of its total foreign currency reserves.
You can see above that over the past year (October 2017-October 2018), Turkey’s Foreign Currency Reserves averaged about $135 Billion, nowhere near its Foreign Debt Owed of $200 Billion.
The reason behind Turkey’s inflation are important, but more important is how the Turkish central bank responded to inflation, or more accurately, how it didn’t.
To tame inflation, the central bank should normally immediately raise interest rates. Interest rates need to be raised in order to avoid something called capital flight. Capital flight is when foreign investors and corporations invested in Turkey, pull their assets out of Turkey. They sell their holdings in Turkey, convert their cash back into their domestic currencies ( eg. an American company doing business in Turkey would sell a factory, convert the proceeds into US Dollars), and leave the country.
Capital flight is the worst possible scenario for an inflation-ridden country, because capital flight is a double whammy; it depresses the value of the local currency (Turkish Lira in this case) as foreign investors sell Lira and convert to their respective domestic currency (US Dollars in our example). In Turkey’s case, capital flight further depressed the Lira, after inflation had already taken a toll on the Lira.
If interest rates aren’t immediately and aggressively raised above the rate of inflation, the currency of the country is destroyed under the weight of inflation and capital flight.
Sometimes inflation is easy to measure, and other times it is not. In the case of Turkey, it is relatively easy to measure inflation. Inflation is usually measured by the change in the value of the currency. The Turkish Lira, and most other currencies in the world that have an export industry (and consequently receive foreign direct investment, foreign currency) are benchmarked against the US Dollar. The reason for this is that Turkey’s largest trading partners either pay in US Dollars, or pay in currency that is pegged or convertible into US Dollars. The below table shows a list of Turkey’s largest trading partners, with data from WorldStopExports.com.
|Top 10 Turkey Trading Partners||Amount of Exports||% of Total Turkish Exports|
|United States||$11.9 Billion||5.1%|
|South Korea||$6.6 Billion||2.83%|
|United Kingdom||$6.5 Billion||2.8%|
There are 2 trading partners in the list that do not have currencies either pegged or easily convertible to US Dollars. They are Russia and Iran; both are not easily convertible as a result of US sanctions. Russia and Iran only amount to 10% of total Turkish exports, which means Turkey could not rely on those two countries to absorb its exports and replenish currency reserves in the event of USD or Euro capital flight.
By the way, the Chinese Yuan is pegged to the US Dollar, meaning trading in Yuan is essentially the same as trading in US Dollars.
The gist of the above is that Turkish inflation is therefore easily measured by the value of Turkish Lira versus the US Dollar, the main currency it’s exports are directly or indirectly paid for.
The above chart shows the Turkish Lira exchange rate against the dollar, and also an additional line showing the Turkish Central Bank interest rate. Notice that the Turkish Lira did not begin to gain value against the US Dollar until the Turkish Central Bank raised rates all the way up to nearly 25%. Notice also that between October 1st, 2017 and June 7th, 2018, the Turkish Lira lost 33% of its value (from 3.5 Lira per US Dollar to 4.5 Lira per US Dollar). During that time, the Central Bank took no action to tame inflation. On June 7th, 2018, it finally took action, raising rates from 8%, to about 17.75%, as Reuters reported.
Unfortunately, it was too late, because capital flight had already begun. That is why between June 7, 2018 and September 13, 2018, the currency tumbled even further, losing an additional 33% of its value.
On September 13, 2018, the Turkish Central Banks made an unprecedented interest rate hike from 17.75% to 24%. Since mid-September, inflation and the Lira, have stabilized.
You can also see below that Turkey’s foreign currency reserves have started to rebound ever since the last interest rate hike to 24%. This is evidence of foreign capital returning to the country; more concretely, this is US Dollars coming back into Turkey, being exchanged into Turkish Liras, and invested into the country at that very high interest rate.
The question then becomes, how would a country like the United States measure it’s inflation rate? The US Dollar is a world currency, and therefore it’s value is relative to a whole basket of foreign currencies; this makes it much more complicated to value.
With that said, the US Dollar Index is not very accurate; the basket of currencies used to measure the US Dollar doesn’t included China, the largest trading partner of the United States. This makes the US Dollar Index flawed.
The best way to measure US inflation, therefore, is by measuring it in the actual prices of things. There are several inflation indicators: 3 of the biggest ones are:
- Consumer Price Index (CPI) – measures the change in price of things typically bought by consumers, such as food, fuel, insurance, and airfare, among other things.
- Producer Price Index (PPI) – measures the change in price of things typically sold by domestic producers, i.e factories. Think of these things as raw material, or things like steel, aluminum, lumber, glass, etc… things that consumers don’t buy directly, but things that do go into the things consumers eventually buy.
- Personal Consumption Expenditures (PCE) – also measures the change in price of things typically bought by consumers. You can read more about it here.
Of the three, the two most commonly used are the first (CPI) and the third (PCE).
In order to compare the price of things over time, we need to adjust them for inflation. In other words, $265 today may not get you much, but back in 1924, that was the price of a brand new Ford Model T.
Recall above, we noted that the Dual Mandate of the Federal Reserve is to,
- Maximize Employment
- Stabilize Prices.
One thing that many of us don’t realize is that wages, or the price employers pay for labor, is a component of inflation, and the price of things. In order for prices to be stable, wages must also be stable, because although most of us consider wages as something we earn, companies consider wages a price paid to do business.
The most important “price” of anything, is the price of labor.
The above chart is a very important chart, and we’ll take some time now to understand it. The blue line is the price of labor, inflation adjusted using the Consumer Price Index.
The Consumer Price Index, or CPI, is a number that is either above or below 100. If we were to measure inflation starting in 1980 for example, we would set the CPI number to 100 in 1980. After 1980, when CPI is above 100, that means the US experienced inflation since 1980. When it is below 100, that means the US experienced deflation since 1980. When the CPI decreases from one measurement to another, that also means the US experienced deflation between the two measurements. For example, if CPI was 102 in 1990, and 101 in 1991, that means the US experienced deflation between 1990 and 1991.
In the above chart of CPI, we see the value of the index since 1982. In this chart, the value of CPI is “zeroed” at 100 in the period 1982-1984. That just means the average of all the values of the index between 1982 and 1984 is 100.
How do we read the index value? That can be illustrated with an example. In June 1990, the value of the CPI index was 129.9. This simply means that what would have on average cost $1 between 1982 and 1984, costs $1.299 in June 1990.
In order to adjust the price of labor (blue line, first chart) for inflation, we divide the price of labor by the CPI index, and multiply by the most recent value of CPI.
Don’t worry if you don’t understand this math. Basically, we are simply taking a ratio of the most recent CPI reading, to every historical CPI reading, and multiplying by the price of labor. This adjusts all the past readings of labor prices for consumer price inflation.
The following is very important. When we adjust Labor Prices, or Wages, for consumer price inflation, it means we are subtracting out consumer price inflation from wages, so that we can isolate labor prices. It allows us to see how much extra money laborers have, after the cost of basic products they buy is subtracted out. In a way, it tells us how much purchasing power laborers have, to buy stuff above and beyond the basics.
The red line on the above chart is the Federal Reserve’s target interest rate. This is the rate the Federal Reserve has been raising recently, much to the chagrin of Donald Trump. I’d like to direct your attention to the correlation between the two lines; up until the mid 1990’s, they look very, very similar.
Furthermore, the red line looks like it very well could equal the blue line, but shifted to the right a little. This means that the red line seems to be a response to the blue line, a delayed response.
In reality, that’s exactly what it is.
When the Federal Reserve sees wages rising too high too fast, they raise interest rates, and sometimes, they raise them too much. They overdo it. You can see that they overdid it in the early 1980’s, probably because they responded to what looked like wages going higher again in the late 1970’s, after having come off slightly in the mid 1970’s.
In recent time, we can see that the blue line has risen very high, almost as high as it was back in the 1970’s. And yet, the red line is still near 0!
What this means is that wages, adjusted for consumer price inflation, have actually risen back to where they were in the 1970’s, and yet interest rates are nowhere near where they were back then.
This chart may explain why the Federal Reserve and Jerome Powell are determined to stay the course and raise rates. Jerome Powell’s Federal Reserve are very concerned about the gap between labor prices, adjusted for consumer price inflation (which is what the blue line represents), and interest rates (represented by the red line).
The reason why the gap is such a concern is because if history repeats itself, we should expect that Labor Prices will rise substantially, which will then require a substantial move higher in interest rates. If history repeats itself, labor prices are about to become very, very expensive.
This may sound good for labor, but since hourly workers do much of the production work in the US, labor prices will most likely trigger a gigantic increase in the CPI (price of things bought by consumers). That in itself, will hurt the economy.
To combat inflation, the Federal Reserve will have to dramatically raise interest rates. That will be a double whammy on the economy, as higher interest rates restrict the availability of money.
All told, it will most likely add up to a recession.
The reason why the Federal Reserve has allowed the gap between the Red and Blue Lines to get so large is because of the economic destruction that occurred during the 2008 Great Recession. Inflation was elusive for so long; it persisted below 2% for years after 2008.
With that said, the time for cautious policy is over. The gap between monetary policy and labor prices (minus consumer price inflation) is far too large. Despite Donald Trump’s objections, the Fed must stay the course.