Economics: Did We Reach Peak Interest Rates?

(Drivebycuriosity) - I think we reached the peak of the recent interest rate cycle. The interest rates went up because the Federal Reserve needed to fight against the red hot inflation. Their inflation target is 2%.

 

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We already passed the peak of the inflation in June 2022 with 9.1%. Since then the inflation rate dropped to 5%, a minus of about 4 percentage points.

 

 

                    Peak Monetary Growth

 

 

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The high inflation rate was caused by a flood of money in the past. In 2020 & 2021 the US government flooded the economy with stimulus checks in the value of trillions of dollars (American Rescue Plan), supported by huge bond purchases by the Federal Reserve . 

The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & deposits at banks).

Over two years the US money volume M2 jumped about 40% as a result (the FRED charts above display a huge hunchback  fred.stlouisfed). The money deluge met a constraint supply of goods & services, partly because of Covid19. It is no surprise that prices had to increase so much (marginalrevolution).

 

 

                  Quantity Theory Of Money

 

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But the monetary growth - the engine of the inflation - peaked already in February 2021 (with plus 27%). Since then the monetary growth rates have been falling and turned negative in December 2022. In the recent months the money supply was shrinking! "We have never seen money taken out of the economy like this in our history" ( twitter.com).

The causal connection between money and inflation is known since the 16th century at least. Nicolaus Copernicus described already in the year 1522 how "too much money" causes inflation. Copernicus` "quantity theory of money" is based on observations:

The Spaniards had conquered today`s Latin America and looted the silver stocks. They send the precious metal to Europe where is was used as money. As a result the European money volume jumped, meeting a restrained supply of goods (agriculture, hand works) &  services. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level.

Elaborated studies by Milton Friedman, Karl Brunner, Allan Meltzer and many other economists (known as Monetarists) described already in the 1960s how and why the inflation rate follows the growth rate of money with a time lag (causal connection). 

During the recent cycle inflation peaked 14 months after the peak of monetary growth (time lag). The inflation causing money flood has certainly ebbed out. 

We can expect that inflation will continue to follow the moderation of monetary growth. By end of the year an inflation rate of about 2% could be reached which would translate into significant lower interest rates.

 

 

                 Cooling Producer Prices

 

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The US producer prices, which don`t include rents and services like health care & education, cooled even more and come already close to the 2% inflation target.

There are also signs that the real economy (industrial production, retail, jobs) is cooling. 

It´s time that the Fed starts to cut her interest rates, otherwise the economy may slide into a severe recession.