Fed Raises Rates to 3.75%-4%: Effects on Inflation, Debt and AI

The Federal Open Market Committee (FOMC) recently decided to raise the target range for the federal funds rate by a quarter of a percentage point, bringing it to 3.75% to 4%. This marks the first rate hike since July 2023 and is intended to support the Federal Reserve's dual mandate of maximum employment and price stability. The committee noted that economic activity is expanding at a solid pace, with resilient domestic spending, strong productivity growth, robust capital investment, and stable job gains. However, inflation remains elevated, and the policy action aims to facilitate a timelier return to the committee's 2% inflation goal.

The Elephant in the Room: Investor Sentiment vs. Consumer Reality

A critical question surrounding this decision is whether it will initiate a series of rate hikes or if the Fed will quickly backtrack. This largely hinges on a significant disconnect between how investors and the average consumer perceive the economy. While investors, often on the "right side of the K" (referring to a K-shaped economic recovery), may feel optimistic, many ordinary people are struggling. Consumer confidence is low, with many concerned about job security and their ability to make ends meet.

This sentiment is not fully captured by official labor data. When considering individuals who have left the labor force entirely, the labor force participation data appears much worse. The Fed's focus on trends, while commendable, seems to overlook the struggles of those on the "wrong side of the K," whose feelings about the economy ultimately drive their spending and borrowing decisions.

Inflation Drivers: Fed's Influence vs. External Shocks

The effectiveness of the Fed's rate hike in controlling inflation is debatable. While the Fed aims to influence inflation, it's crucial to consider whether they are truly influencing the rate or merely reacting to existing economic conditions. The example of Japan, which experienced decades of stimulatory environments without significant economic growth, highlights the importance of public sentiment. If people are fearful rather than optimistic, they may not respond to economic stimuli as expected.

The current inflation is largely attributed to two factors: tariffs and oil disruptions. Neither of these can be directly addressed by raising interest rates. The Fed's traditional approach to supply shocks, such as those in the Middle East, is to "look through" them, assuming they are temporary. However, the ongoing geopolitical instability, including conflicts in the Middle East and the Russia-Ukraine war, suggests that these energy disruptions may be more persistent than anticipated.

Experts are warning of an energy crisis, with Russia halting diesel exports, Saudi Arabia canceling crude exports to Europe, and rumors of the US considering slowing its diesel exports. If inflation is driven by a sustained interruption to energy supplies, which underpins all prices, then raising rates may not be an effective solution. The Fed is making a bet that these disruptions are not a primary concern, focusing instead on reducing the availability of cheap money. However, if inflation is due to supply-side issues rather than excessive demand, this strategy may prove ineffective.

Disconnect in Economic Perceptions

The Fed's assessment of a strengthening American economy, citing new hiring, private sector earnings, and business capital investment, contrasts sharply with the experiences of many. While some, particularly those in elite circles or investors, may feel optimistic, a significant portion of the population, including Gen Z, does not share this sentiment. The current economic landscape has been favorable for those invested in equities due to deficit spending, money printing, and persistent inflation from the COVID era. However, for those living paycheck to paycheck, it's a very different and challenging time.

The Fed's reliance on official labor market data, such as a low jobless rate of around 4.1% and increasing job openings, is criticized for not accounting for individuals who have stopped looking for work. This "ejection" from the labor force, particularly among young people, is seen as a sign of weakness rather than strength.

The Debt Burden and the Role of AI

The rising national debt, now exceeding $40 trillion, presents a significant challenge. The interest on this debt is already the largest single line item in the budget and is projected to grow. Raising interest rates exacerbates this problem, making it more expensive to refinance the debt. The Treasury is attempting to manage this by shifting debt to short-term instruments and exploring innovations like stablecoins backed by US debt.

The current economic growth projections of 2.3% this year and 2.4% next year are considered low. There's a strong reliance on artificial intelligence (AI) to drive productivity gains and economic growth. If AI fails to deliver sufficient growth, the compounding interest on the debt could become unsustainable, potentially leading to a faster transition away from the dollar by other nations.

Bond Market Signals and Economic Instability

Long-term bond yields have been rising, indicating a lack of trust in the Fed's ability to control inflation. This is partly attributed to economic strength, competition for capital (especially from "hyperscalers"), and geopolitical factors. The 10-year Treasury, a crucial global asset, is seeing increased yields because investors are not confident that the Fed can beat inflation without sufficient economic growth.

The current economy is described as precarious, not grounded in real wage growth for the middle class. Instead, it's driven by the wealth of those at the "top of the K" who are making significant profits from asset speculation. This creates a facade of economic health, masking the struggles of nearly half the population. If AI doesn't come to the rescue, and the debt becomes a problem, the economy could face a severe downturn. Historically, significant economic growth was necessary to overcome debt burdens, as seen after World War II.

The Dilemma of Rate Hikes in a Complex Environment

The decision to raise rates is a difficult one, especially given the current global instability. Ongoing conflicts and energy disruptions are likely to keep prices elevated, and these are factors that cannot be controlled by interest rate adjustments. If the Fed continues to raise rates in response to inflation driven by supply shocks, it may mistakenly attribute the inflation to excessive demand, leading to further rate hikes that could harm an already struggling segment of the population.

There's a concern that a decline in inflation could occur not because of the Fed's actions, but due to a "crisis-led decline," where consumers run out of money, and stores are forced to lower prices to attract customers. This could create a false impression that the rate hikes were effective, while masking underlying economic rot and a worsening recession.

The Fed's mandate includes full employment, but the official unemployment rate may not accurately reflect the true state of the labor market due to the exclusion of those who have stopped seeking employment. This disconnect between official data and the lived experiences of many Americans raises questions about the appropriateness of the Fed's policy decisions.

Ultimately, the effectiveness of this rate hike will depend on how the energy crisis unfolds, the pace of AI-driven growth, and the ability of the economy to manage its substantial debt burden. The coming months will reveal whether this "risky move" by the Fed will achieve its intended goals or exacerbate existing economic vulnerabilities.