…The March 2022 Consumer Price Index was released earlier today (April 12, 2022), and it is being reported as being an 8.5% rate of inflation when compared to the March 2021 CPI number…but that was before the Ukrainian War. The War and sanctions have produced…inflation primarily related to energy and food for now, but…if we annualize this…then this becomes a 15.4% annual rate of inflation…This is an extraordinary leap in inflation…
This version of the original article by Daniel Amerman of danielamerman.com has been edited [ ] and abridged (…) to provide you with a faster and easier read. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.
#$$4$ The last time inflation rates were this high, interest rates were even higher…Inflation averaged about 10.4% in 1981 – but three month Treasure yields averaged about 14%, so savers were still coming out ahead by over 3.5% per year. They were making money faster than inflation was destroying the value of that money…
It was no coincidence that interest rates were well above the rate of inflation in 1981. This was a deliberate strategy by Fed Chair Paul Volcker, who was deliberately creating steeply positive real rates to smash interest rates down…This policy ultimately worked – but the price was multiple years of very high interest rates crushing the investment markets while also creating recessions and mass unemployment.
Very high interest rates remain the best method that central banks have to control very high rates of inflation – which is useful information to have for those who have investments that would be impacted by very high interest rates.
What Volcker did is a core part of macroeconomic theory that has been further refined, and is now referred to as the Taylor Rule.
The Taylor Rule formula says that the best way for the Fed to bring down a persistent 15.4% rate of inflation is to bring the Fed Funds rate up to 24.1% (leaving aside the output gap). To be clear – that is for a persistent annual rate of inflation, not an annualized one month rate of inflation… In practice, we will get a better grasp of the real rates over the coming months and years, and they could be lower – or they could be higher as well.
Interest rates moving to 24% may sound like a bizarrely improbable scenario – much like 15% inflation rates may have sounded bizarrely improbable several years ago. However, 24% interest rates are literally the textbook solution to a 15.4% rate of inflation, and anyone who has investments that would be affected by a move to 24% interest rates, should be well aware of this textbook answer, as well as the alternative.
The alternative to 24% interest rates is to let the 15% inflation continue. This is a truly toxic level of inflation that would be very painful for the entire population, and for retirees in particular.
…There are several different ways that retirees who are not protected can deal with inflation, and none of them are pleasant. What is shown in the graph above…is the third option of C. For 15% ongoing inflation this answers the question of how much money can a retiree spend each year if they are to maintain a level standard of living for the entire period of a planned retirement, which is 20 years in this example.
If the money isn’t going to run out, and the standard of living isn’t going to be reduced, then losing 15% per year to inflation requires an immediate reduction in standard of living by 83%. Mathematically, cutting back to 17% of the planned standard of living that would have been supported by the savings with no inflation, will indeed produce a level standard of living for the full 240 months in purchasing power terms (and cutting back by 82% or less just means that the money runs out early or the standard of living falls).
…The problem is that inflation is an exponential series, where we haven’t seen the exponential compounding of high rates in many years. This builds over time in a way that is simply not intuitive, and it is fair to say that the average current or future retiree likely has no concept of what high rates of inflation can do to their financial plans over the long term.
The Fed can break the inflation but, the 24% interest rates would likely break the markets, perhaps bringing about another global financial crisis. However, if the Fed doesn’t pay that price, and we see a return of the persistent wage/price cycle form of inflation, then that inflation can just run and build – until the decision is made to raise rates sufficiently, and then we get the market crash anyway.
The Federal Reserve is truly stuck between a rock and hard place at this point and, unfortunately, so are we all.
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