Why interest rates will likely rise faster than inflation

Is higher inflation just around the corner? That seems to be how the bond market sees it: As soon as traders heard Donald Trump had won the presidency, bond yields spiked (chart below). That’s because it’s widely assumed that inflation and interest rates will be higher under Trump than they would have been under Democrat Hillary Clinton.

Two reasons explain the expectations of higher interest rates and rising inflationary pressure with Trump rather than Clinton as president. First, although both candidates talked about the need for infrastructure spending, the likelihood of it actually happening is much higher for Trump. Republicans would have blocked virtually anything Clinton tried to do, just as they did to Obama, but a Trump infrastructure proposal is likely to be approved. 

Second, chances of a large tax cut and a huge increase in the federal budget deficit are also very high with Trump as president. Both possibilities would increase aggregate demand and put upward pressure on prices.

Inflation since 1960
Federal Reserve

But while I agree that tax cuts and a rising deficit will push inflation higher, I don’t believe the result will be that inflation rises above the Federal Reserve’s target of 2 percent, except perhaps briefly. Instead, I would expect higher interest rates.

Why? The Fed is already quite hawkish on inflation, and even if the central bank’s makeup doesn’t change under Trump, I’d expect the Fed to hike interest rates quickly and aggressively if there’s any chance of inflation rising above the target rate of 2 percent for a sustained period of time. 

The Fed’s board of governors now has two openings that Republicans have blocked Obama from filling, but Trump won’t have to worry about the Senate approving his nominees. That, along with subsequent appointments as board members step down or reach the end of their terms -- and the chance that Trump replaces Fed Chair Janet Yellen with a more hawkish leader -- will shift an already hawkish Fed even more in that direction. (Trump has made contradictory statements about whether he’ll replace Yellen.)

Any hint that inflation is picking up will be met with immediate and aggressive increases in the Fed’s target interest rate.

But the central bank has had trouble pushing inflation up to its target level of 2 percent in recent years (chart below), so why should we believe it could bring inflationary pressure down if it threatens to go above target?

Increasing interest rates when the economy is overheated and inflationary pressures are building is often described as “taking the punch bowl away just as the party is getting started.” So we can think about recessions as a time when the Fed brings the punch bowl into the room. But here’s the asymmetry: If the punch bowl is gone, it’s not possible to drink any more, but bringing the punch bowl into the room doesn’t guarantee anyone will drink it.

Inflation since 1960
Federal Reserve

That is, an increase in interest rates of sufficient magnitude during a boom (taking the punch bowl away) will reduce business investments, purchases of durable goods on credit by consumers (e.g. automobiles) and demand for housing. That cuts aggregate demand and blunts the upward pressure on prices. 

But a cut in interest rates during a recession doesn’t ensure that consumers and businesses will spend more. If businesses expect demand to be low in the future and if they aren’t producing at full capacity due to the recession, why would a cut in the interest rate induce them to invest in more productive capacity? 

If consumers are worried about their jobs, and many are unemployed, how willing will they be to buy a durable good on credit just because interest rates fall? And to make it worse, while there’s no limit to how high interest rates can be raised to combat inflation, there is a limit -- the “zero bound” -- to how far they can be reduced (essentially, the Fed runs out of punch before the party really gets going).

For this reason, the Fed’s ability to reduce inflationary pressures when the economy is strong is much greater than it’s ability to create inflation when the economy is weak.

As the economy continues to recover and nears what appears to be full employment, I believe the Fed should allow inflation to run above target for a period of time. During the recession, many Americans stopped looking for work and left the labor force, but as the economy has improved lots of them have been drawn back into employment. A booming economy is a time when firms have trouble finding workers to fill open positions, which leads to rising wages, and that could draw even more people back to work. 

The more people that are working and contributing to the economy rather than living off social services, family or other means, the better off the country will be. The Fed can bring inflation down quickly when it needs to, and it would be a mistake to raise interest rates too soon. The small cost associated with a brief bout of inflation is more than worth the potential benefit of having more people gainfully employed.

But it’s not very likely that the Fed, as it’s currently constituted, would be willing to allow inflation to run above target for as long as needed to be sure that the flow of people back into the workforce has ended. And it’s even less likely that a Fed with Trump appointees, and perhaps a Trump-appointed chair, would support such a policy.