This month, the Fed decided not to raise interest rates, and traders responded by driving the Dow Jones Industrial Average to an all-time record.[1]

Why?

Apparently, the market believes that the next Fed move will be to decrease interest rates, presumably because the Fed believes it has beaten inflation.

“Inflation has eased from its highs, and this has come without a significant increase in unemployment,” said Fed Chairman Jerome Powell.[2]

In this post, we examine the connection between interest rates and inflation.

Though the Fed doesn’t publicly explain how it believes interest rate policy works, we posit two primary causal links between interest rates and inflation. Both of these links affect inflation through their effect on the money supply. These links are:

1. The interest rate paid on reserves (called the Interest On Reserve Balance or IORB rate)

2. Direct Fed intervention in the capital markets (called quantitative easing or quantitative tightening)

Fed Chairman Powell has stated that he sees no connection between inflation and the money supply.[3] But that merely reminds us of the answer to the question, “How many legs does a dog have if you call the tail a leg?” The answer of course is four, because calling a tail a leg doesn’t make it one.[4] Inflation, as was well understood by the most successful chairman in the history of the Fed, Paul Volcker, is a function of money supply growth.[5] (For more information on the connection between inflation and the money supply, request a chapter of our book on inflation, “Politicians Spend, We Pay,” here.)

The rate of interest paid on reserves indirectly affects the money supply.

Fed purchases — or sales of securities — directly affect the money supply, and simultaneously affect the level of interest rates, the shape of the yield curve, or both. 

Inflation is almost exclusively the result of a rapid increase in the money supply.

Quantitative Easing and Quantitative Tightening

During the Financial Crisis, the Fed, for the first time, implemented a policy of quantitative easing, in which they directly purchased over a trillion dollars of assets. The Fed bought up much of the “bad debt” of the banks, including debt securities such as mortgage-backed-securities. To pay for these purchases, the Fed created new money out of thin air. This new money increased the money supply, and offset what would otherwise have been a contraction in the money supply. That contraction would have been the result of the various banks and investment banks having to write down the value of bad debt holdings. Instead, they got to sell the bad assets to the Fed. The increase in the money supply caused by quantitative easing offset a large amount of loan losses and the net result was neither a big increase nor a big decrease in the money supply.

Quantitative tightening is essentially the reverse of quantitative easing. The Fed, instead of buying bad debt and injecting money into the banks, sells good securities to the banks. The banks then pay money to the Fed, decreasing the money supply.

Interest on reserve balances

Everything else equal, when the Fed increases the interest rate that it pays on reserve balances, banks place more funds on deposit with the Fed. Money on reserve is not lent out. Everything else equal, this means that there is less money available for the banks to lend to businesses and consumers.

When consumers and businesses face higher borrowing costs, everything else equal, they will borrow less. There is less investment, and less economic activity overall. The money supply shrinks. Inflation falls, and if the money supply continues to shrink deflation can result.

Conversely, when the Fed lowers the interest rates on reserves, banks have less incentive to keep money on reserve. They therefore lend it out to businesses and consumers in a higher volume than if interest rates were higher. Everything else equal, businesses borrow more, and invest more. The money supply grows, and this creates inflation.

Quantitative tightening

When the Fed sells bonds, the Fed receives cash. That cash is then no longer part of the money supply. At the same time, as a direct consequence of the Fed selling bonds, everything else equal, bond prices fall.

As is well known, when the price of bonds decreases, the yield (the interest rate) increases. (If you find yourself having to explain this to clients over and over, please request a chapter of our forthcoming book, “The Investor’s Dilemma Decoded,” here. Maybe we can save you some time.)

Recession ahead?

No one can predict the future, but there is a direct connection between inflation and GDP, as we wrote about in this post, “Does Falling M2 Signal a Recession?”

The money supply has been contracting for the past year. Almost by definition, that means nominal GDP will fall, or will grow much more slowly, as the contraction in money supply works its way through the economy. Falling GDP is a recession.

To learn more about inflation and interest rates, request a copy of our book on inflation, “Politicians Spend, We Pay”, here. Or, call Connor at the office: 703 437 9720.

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[1] https://www.axios.com/2023/12/13/dow-jones-stocks-record-high-interest-rates

[2] https://www.youtube.com/watch?v=v3QDjrpT8HU

[3] In February of 2021, Powell stated that the growth of M2 “doesn’t really have important implications for the economic outlook.” This is just one of several such claims. https://www.wsj.com/articles/powell-printing-money-supply-m2-raises-prices-level-inflation-demand-prediction-wage-stagnation-stagflation-federal-reserve-monetary-policy-11645630424

[4] https://quoteinvestigator.com/2015/11/15/legs/

[5] https://www.stlouisfed.org/publications/regional-economist/january-2005/volckers-handling-of-the-great-inflation-taught-us-much