Inflation, interest rates and more on the economy

When my wife and I were commuting to Northern Illinois University for my Ph.D. and her Master’s, it was not unusual for us to go up to a night class in perfect weather and come home in a colossal snow storm. This was before I-88 was built. One night we were coming home, and the drifts had reduced the old country road to one lane.

In the sky two lights appeared through the snow, they kept coming closer and closer, I thought we were going to be beamed up and meet ET or get dissected. When the lights were nearly on top of us, I realized it was a BUS coming down from a bridge. I was forced to take the snow bank and the VW Bug I was driving lifted off the ground three feet.

That was an unpredictable and scary outcome.

The recent crash in the stock market that some want to call a “correction” is just as scary but not unpredictable. I have been forecasting that result in my classes for the last two months. That doesn’t make me a genius. It simply says I know the principles of economics.


The Mechanics

Remember if the economy is allowed to function without monetary and fiscal policy it will go through four stages of the business cycle and sometimes five on average every 8.4 years. The stages are: Depression (high unemployment, declining prices, and high underemployment), Creeping inflation (prices rising moderately 0-6%, near or at full employment, moderate growth), Hyperinflation (Prices rising more than 10%, near full employment, and the market system losing its ability to ration goods), Recession (falling prices, rising unemployment, and at least two quarters of negative GNP), the last stage is rarely seen Stagflation (rising price, high unemployment, and negative growth).

Currently, we are in creeping inflation with prices rising at 2.1% and unemployment at 4.1% which is considered full employment.

Monetary (Federal Reserve control of the interest rate and money supply) and Fiscal policy (changing taxes and government spending) are used to keep us in creeping inflation. If prices were to jump the Fed will raise interest rates and money will flow out of stocks and the stock indexes will decline. This is due to the fact that the stock market theoretically balances the return on stocks with the interest rate on bonds and other less volatile investments. If the interest rate goes up, then money will flee the stocks and the stock prices will drop.

The next thing we need to know is that hedge funds and other big-time market investors bet on the volatility of the market. The exchange-traded volatility notes (VIX) measure how volatile the price of stocks.

An interest rate hike by the Fed due to expected inflation, if announced long in advance doesn’t shake up the betting on the VIX. If a sudden fear of inflation occurs and the resulting unexpected increase in interest rates shakes up the VIX, those betting on stable conditions will get burned. Over the last several years the VIX has been stable, and the money makers have profited from betting on stability.

So if we are at full employment, then the supply curve is perfectly inelastic theoretically, and the intersection with demand sets the consumer price index. Small increases in demand with slightly rising wages keep us in creeping inflation, and we have seen for some time that increasing employment has not lead to a tight labor market, so wages have not increased much. Demand has been relatively stable.

Trouble is if prices rise unexpectedly due to demand increases then the likelihood of the FED increases in interest rates faster will increase volatility in the market suddenly. (How much will they raise it? When will they raise it? Is the shift in demand temporary? What will the Fed Chairman recommend? etc.)

So last month the Republican Congress and President exercised supply-side economics (give tax breaks to corporations and rich individuals, and they will invest in more production and increase jobs. Theoretically the rich will put their money in savings and supply of saving will increase and interest rates will fall. So businesses can borrow cheaper and build.)

Enough with the theory! What happened last week was that the government reported that wages increased at an unexpectedly high rate. Logic dictates that demand will increase due to the tighter labor market. So the FED will respond with higher interest rates. Add to that the fact that some corporations gave bonuses to their workers in the form of higher wages to get better workers and keep the ones they had, so the money was not invested in new plant and machines.

Add to that the expectation that Congress will pass a huge deficit-oriented budget which in order to be financed will require the government to borrow heavily. This will increase the demand for money offsetting the supply side increase in the supply of money and interest rates will not fall. (This is called the crowding out effect and Congress did pass the huge deficit budget.)

Every theory listed about is taught as principles to all Lewis students. This is not rocket science!

So what do you think that does to the VIX. Everyone betting huge amounts on stability just got whacked. Some of the exchange-traded investments dropped 95% in minutes. Ouch! Three days later Fidelity Funds stopped trading several VIX exchange-traded instruments.

                In order to cover their losses, they were forced to sell the rest of their stocks at fire-sale prices. Thus, the market drops of 600+ and 1000+ and the value of all our 401(k)s dies.

Add to this that the market was overinflated with expectations that Trump was good for business and the economy. When that euphoria wore thin there was an expectation that the market would correct by 10%.

So there you have it, simple principles.


About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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