Fed raises interest rate again

Up another three-quarters of a percentage point to 4 percent – ​​the US Federal Reserve is expected to raise interest rates significantly for the sixth time in a row on Wednesday. Nevertheless, it struggles to be taken seriously by the financial markets and companies. According to the motto “You won’t believe anyone who has been throwing around too cheap money for too long in the past”, some just wait for the first sign of the “pivot”, while others increase the prices for their goods and services more , as their costs rise.

Inflation does not vanish into thin air

Among the investors, coddled by the «monetary pampering programs» of the past, the naïve hope of being able to make up for the enormous price losses of the past few months in the shortest possible time dominates. They assume that the Fed could soon finish raising interest rates, then wait for the delayed effect and then cut rates again soon after. As if the speculations of investors had not already been disappointed several times in the past few months and as if the general upward trend in prices would soon simply disappear into thin air.

Instead, inflation tends to decline slowly, and then sometimes stays at elevated levels for several years, once exceeding 5 percent. That shows the statistical evaluation of data from the past – and companies like Pepsi, Coca-Cola, Chipotle, McDonald’s, Wyndham Hotels, Darden Restaurants, Jet Blue, Colgate-Palmolive and many others could be responsible for this in these times. This is because they use the inflationary environment to tend to increase the prices for their goods and services more than their costs have risen to date.

Companies raise prices sharply

So it is that «the resilience of the corporate sector one of the surprises of 2022 is», like economist Joe Carson argues. Despite a volatile and uneven economic development and despite a series of interest rate hikes, the corporate sector is at its most profitable for a long time, and profit margins are even record-breaking. In the eyes of the former chief economist at the asset manager Alliance Bernstein, this clearly confirms that the companies are passing on the cost increases or even making substantial gains and are not compensating for them by making their operational business more efficient.

Even before the pandemic, non-financial manufacturing and service companies were generating their highest margins since the mid-1960s. Since then, they’ve apparently been able to simultaneously pass on increased material, shipping and labor costs, and increased real earnings margin by 400 basis points, or a whopping third. That may explain why the American Labor market so far despite significantly increasing nominal wages has remained so robust. In fact, companies in the land of opportunity hired more than a million new employees in the third quarter, about as many as in the previous quarter – and even at the end of September an unemployed person could almost choose between two job offers, at least in theory. Such a thing would not be expected if the companies as a whole were struggling with earnings problems.

The Fed must prevent record profits

“Policymakers will never publicly admit this, but the Fed wants an environment where companies cannot pass cost increases on to retail prices. This would lead to a decline in profit margins,” explains economist Carson. That would be typical of a period of slowing economic growth or even a recession. In his eyes, inflation expectations are “soft indicators” of future price developments, and they only show what those involved would like to see. The “hard benchmark”, on the other hand, is derived directly from economic activities and is shown, among other things, in the form of the company’s profit margins. “Near-record profitability suggests the Fed’s job of fighting inflation is far from over.”

According to this line of argument, the Fed must, also out of concern about an emerging wage-price spiral, put the brakes on monetary policy until companies can no longer raise prices due to falling demand and then start lowering costs and in this framework to reduce staff. Only then should the inflation rate come down – and that just means that prices will rise a little less quickly. There would be no talk of a decline or even deflation for a long time, including interest rate cuts.

Is the economy more overheated than assumed?

The Trump and Biden administrations have unleashed the genie of inflation with their gigantic credit stimulus programs in an extremely easy monetary environment. Now he can’t be brought back so easily. If one believes the analysis results recently published by employees of the American central bank, then the American economy is even more overheated than previously generally assumed.

In the minutes of the Fed’s September rate-setting committee, the US economy’s “potential output” was “revised significantly downward” on the back of disappointing productivity growth and slow labor force participation growth. This means that the institution would have to step on the monetary policy brakes even more than previously assumed.

If you believe the analysts of Hedge Fund Bridgewater Associates, the stock exchanges and probably also the bond markets have only anticipated the valuation effects of higher interest rates in the past few months, but not the consequences of decreasing profit margins. This is exactly what is obviously needed to bring inflation under control. Does Fed Chair Jerome Powell agree? In any case, skeptics fear that the man doesn’t have what it takes to consistently combat the dramatically declining purchasing power of American citizens like his role model Paul Volcker did about fifty years ago. He’ll buckle first.