Should the Federal Reserve raise interest rates in 2022?

I am on team transitory in regards to inflation and think the USA should maintain a very loose monetary policy keeping interact rates basically zero.

The supply chain issue will ease but there will be hiccups throughout this year. Automobiles and the chip shortage make up a huge part of the inflation numbers now.

I don’t think government spending has at all contributed to the inflation numbers, it’s been about a year since the last stimulus checks.

The economy isn’t running too hot. Today’s job numbers came in with only 199,000 jobs created and an unemployment rate of 3.9%. 3.9% is good but it’s not at the 3.5% pre Covid.

I’d keep accommodative monetary policy until at least July and only hike then of Covid gets controlled enough to remove the pandemic label.

If they don’t raise rates eventually, the inflation won’t be transitory.



Do you have an estimate of the natural rate of interest?

Do you have an estimate of the non-accelerating inflation rate of unemployment (NAIRU)?

A massive supply shock is exactly the sort of case where we might expect inflation to start heating up even at higher levels of unemployment. We should not, in general, expect to be able to push the unemployment rate as low as it was previously able to go.



The Fed has already announced its attention to hike rates this year, probably several times. Those announcements are already incorporated into current expectations, and even given those expectations of higher rates, later in the year, the 5-year breakeven is nearly 2.8%.

That’s not ridiculously high. It’s not out of control.

But it’s higher than their ostensible target, over quite an extended time span. It’s hard to argue that a five-year quasi-forecast is somehow “transitory”. That figure would be even higher if the Fed weren’t planning on raising rates this year.

It’s been a long time since I last read a reference to NAIRU :smiley: I don’t believe unemployment is a big concern in the USA right now. But it still is in Southern Europe, specially among the young.

For those of us who lack a finance background, would you be so kind as to explain the 5-year breakeven?

It’s an interest rate spread, the higher it gets indicates that the expectation for inflation is increasing

You can buy a regular bond.

You hand over some money, and the bond’s promise is that you will be given money back. This implies an “interest rate” that the bond is going to pay you (specifically the yield to maturity).

The issue is that this is a nominal rate: measured in money only. But money does not stay constant in value. The amount of goods and services which the money can buy changes, and so the “real interest rate” – which determines how much future stuff you will be able to buy – depends on the level of inflation. Regular bonds (Treasuries) have this calculation of expected inflation cooked into the price.

Lenders need to be paid a real rate plus some compensation for future expected inflation. The interest rate that you see will have both ideas mashed together into one number. You can’t disentangle the two different pieces of information based on this one number by itself.



Ah, but you can also buy Treasury Inflation Protected Securities (TIPS).

These bonds pay out more when “inflation” is higher (as measured by the Consumer Price Index.) This means that the yield on TIPS gives a sort of rough estimate of the “real interest rate”. When inflation is automatically paid for, as it is with TIPS, what is left is the real rate by itself.



These two yields together allow us to algebra out a rough estimate of “expected inflation”.

Regular Treasuries: i = r + \pi_{e}

TIPS: r

Subtract one yield from the other to cancel the real rate r and what’s left is “expected inflation” \pi_{e}. And that is the breakeven. It is one yield subtracted from the other (also called the “spread” between the two rates.) Obviously it’s not perfect, for all manner of reasons, but it gives a rough idea of what people are expecting about possible future price increases.

Very helpful, thanks.

Surely you don’t mean fully transitory. Wage rates are never coming back down, and considering that wages make up just over 50% of our GDP, good luck seeing 2019 prices for goods ever again.

I do agree that inflation due to temporary gridlock in the supply chain (also indirectly due to labor shortages) will revert once those supply chain issues are resolved.

December inflation year over year just came in at 7%. Team transitory isn’t looking very good. And the Fed clearly expects high inflation for some time, as they are planning rate hikes throughout the year and next year.

People think fixing the supply chain issues will tamp down inflation. But supply chain issues have also limited purchasing, which is anti-inflationary. The issue is far more complex than just ‘shortages cause inflation’. Also, economic activity is still down because of partial lockdowns and restrictions. Once people feel free to go out and spend again, inflation could get worse, not better. But we really don’t know, because it’s complex.

The thing is, I’m not sure 25 basis points (the Fed’s aim for rate hikes) will do anything, other than maybe slow the stock market bubble a tiny bit. In the 1980’s it took double-digit interest rates to cool off inflation. That’s no longer possible, as least in a long enough term to have debt roll over at the new rates. At 10% interest, interest on the debt (28.9 trillion last I looked) would be 2.89 trillion dollars per year. The federal government took in 3.8 trillion in revenue in 2021, so this is clearly unworkable.

This is one reason I think inflation will persist. The government, businesses and individuals are in so much debt that any substantial tightening of the money supply will wreck the economy.

Also, at the current rate of borrowing I don’t see how the Fed stops buying government debt, because who else is going to? The U.S. ran a $3 trillion deficit last year. Who can or will lend that kind of money to the government at nearly zero interest rates? China used to be a big purchaser of debt, but that’s in historical terms of a few billion here and there. China holds about $1 trillion in US securities. Japan holds about a trillion, and the UK is third at around $700 billion, I think. Note that the combined debt held by our top three foreign purchasers of debt would not have covered last year’s deficit. And all of them are now facing their own debt crises.

In comparison, the Federal Reserve holds about $6 trillion in debt, paid for with printed money. Somehow that has to be unwound, which would be very painful. But if they truly are going to stop buying treasuries and printing money, I would expect interest rates on treasuries to climb substantially just to entice enough people to buy them.

Politicians recoil from pain like flatworms. So what I suspect will happen is that they will let inflation run, both because they may not have a choice and because the tools needed to bring it under control will not just be painful, but will accrue political damage to whoever supports it.

‘Inflation is transitory’ seems to be as much wishcasting as anything, because the people in power really want it to be that way. Anything else is deep trouble for the political class.

Wouldn’t inflation be of utility for those who have very high debt though? The government would seem to benefit from inflation even if a few individual politicians would not.

Exactly, which is why I think they will let inflation run. There is simply no other way to reduce a debt burden that gargantuan. If the government ran trillion dollar surpluses instead of trillion dollar deficits, it would still take 40-50 years to pay off the debt. It will never happen. So they may just let inflation reduce the debt for them.

But 10% inflation will cost the people holding the treasuries, most of whom are American citizens or their pension funds, to lose 10% of their savings per year. I think Americans hold about 22 trillion of the debt, so they’ll lose 2.2 trillion dollars a year in purchasing power. That’s an awful lot of wealth destruction, but it takes time and is diffuse and much harder to fight against than giant tax hikes or spending cuts. So inflation may impose a lower political cost than a deep recession to shrink the money supply, or attempts to raise taxes by trillions of dollars.

Politicians will likely fight the Fed anyway. I can see a scenario where the fed attempts to tighten, which causes a recession, which the government responds to with more ‘fiscal stimulus’, undoing the money supply moves by the Fed. This is essentially what Carter did to Volcker at first.

Then we will get to see what happens when the world realizes that the world’s reserve currency is being intentionally devalued. Nothing good, I’m sure.

Debt held by the public is 22.3 trillion.

The trust funds that hold the other 6.1 trillion are essentially an accounting gimmick. I could write a piece of paper saying “I owe you six trillion dollars”, address it to myself, sign it, and put it in my safe. This piece of paper would then have the same effect on the international financial markets as the trust funds do. (There are political knock-on effects from the trust funds, for example friction from the debt ceiling debates. But the immediate financial effect is precisely nothing. It’s taking a dollar out of one pocket, and putting it into the other pocket.)

This is a straightforward Keynesian interpretation of the 1970s.

But it simply is not true. If Volcker had persisted in tightening under Carter, the inflation rate would have gone down regardless of any fiscal deficits.

We know this would have happened, because it did happen under Reagan.

Spectacularly so. Debt held by the public as a percentage of GDP was around 25% in the 1970s, right through the Carter administration. That lasted until the Reagan administration, when deficits exploded, and eventually the debt as a percentage of GDP reached over 40%.

Fiscal policy was strongly “expansionary” but that simply didn’t matter for the inflation rate or nominal interest rates, both of which started to come down after the main bout of tightening was accomplished. (The interest rate had to go up in order to come down.) The Reagan era was disinflationary despite the debt explosion. The Volcker monetary tightening was more important to inflation than the fiscal deficits, and that was true year after year.

It’s a child against a sumo wrestler in a game of tug-of-war. When it comes to the nominal aggregates, money is cheaper, faster, and far more powerful than fiscal policy. In a debt crisis, that could change. But we’re not, yet, in a debt crisis.

Volcker backed down under Carter. He didn’t tighten in earnest until Reagan took office.

The Fed is only somewhat insulated from political pressure. Fed chairs know which way the wind is blowing, and in the past have deferred to presidential pressure.



As for the future, you have a plausible story. The pieces hold together. You could very easily be right. If you are convinced that you are correct, then of course you should be borrowing up to your eyeballs on fixed-interest USD loans.

But I’d just point out – again – that the markets do not yet believe you.

The 10-year breakeven is even lower than the 5-year. That could be a mistake. If it’s wrong, it’s wrong. It happens. But reality does not necessarily have to match the stories people like to tell themselves. Countries have blown up their own monetary systems before, and they’ll do it again. The US could potentially be one of them. It’s possible.

But I doubt it, at least on the timeframes I’ve been mentioning. I don’t think average inflation, over either a five-year or ten-year period, will be higher than 5%. I’d be a bit surprised if it’s higher than an average of 3% annually over the next ten years. There’s not infinite slack here, but there often tends to be more slack in a highly developed country than people give credit for. Often much more.

The secular trend for interest rates has been down, down, down, down for the last four decades, simultaneously with the debt load going up, up, up, up. Not just in the US. Internationally. We don’t actually know where the limit of all that hunger for USD is. But an inability to imagine what those buyers might look like does not imply they don’t exist, especially given that they’ve been showing up reliably, in mass, globally, for damn near forty years.

I agree with most of what you said, and I’ve careful to couch any ‘predictions’ with an appropriate amount of uncertainty. As I said, we are dealing with complex systems, and nothing about the future is written in stone.

That said, your 5%-for-five-or-ten-years sounds like a reasonable guess. Note that this is way above the Fed’s target, thoug(.

As for buyers continuing to show up to buy U.S. debt because they always have… The U.S. is about to lose the Social Security Trust Fund purchases, China and Japan are no longer looking like an endless well of capital, and the Fed says they are going to wind down their purchase of treasuries. In the meantime, the U.S. is borrowing huge amounts of money every year.

What can’t continue, won’t. The question is whether the current state of affairs will continue, and how long you can continue to borrow trillions of dollars and expect to find buyers for your debt at low interest rates…

Today’s producer inflation number came in at 9.7%.

(paywall)
Jason Furman who, for my money, is the sharpest analyst for the US economy today, thinks inflation will be a worry for 2022 but note that means around 3-4% inflation.

Several of the factors he discusses should be in retreat in 2023. The earlier fiscal stimulus and accumulated savings would have petered out and one would expect a lot of the supply-chain problems to have ended by then. Also a good chance that Covid will have finally settled down as an endemic disease by then. The US will probably have moved to divided government which will also mean lower deficits with Biden vetoing tax cuts and the GOP blocking higher spending.

So just when we thought the inflation would get us, we’re saved by our trash political system.

The thing about “team transitory” is that 1) their predictions have been wrong to this point, and 2) they themselves are in retreat, at least in the case of the Fed.

Historically that has been the case. Liberals (like me) like to point out that despite claims to the contrary Democratic presidents do a better job of keeping deficits down the Republicans. But in fact, its only when you have a Democratic president with a Republican Congress.

  • When Democrats have both Congress and the presidency they support big government to help the little guy.

  • When Republicans have both Congress and the presidency they support Tax cuts for the rich and large government contracts to big buisiness.

  • When you have a Republican presidency and a Democratic Congress, then the Democrats will negotiate a combination of increased spending for social programs and big buisiness to keep everyone happy.

  • When you have a Democratic presidency and a Republican Congress, then the Republicans can strut their fiscal responsibility by cutting government spending in hopes that people will be unhappy and the president will get blamed.

Are you sure? In the period since the Great Depression, Congress has generally been, with a few short exceptions, Democratic until the Clinton era. It really seems to be a correlation strictly based on POTUS, regardless of Congressional affiliation.