When it comes to money, people like to act with a herd mentality. We tend to follow what we read, whatever is reported. But did you ever take a pause to understand the relationships between inflation, recession, interest rate hikes, and monetary policy tightening?

Just 2 days ago ( July 27), The Federal Reserve raised interest rates by 75 basis points. This comes after a 75-basis-point hike last month, bringing the policy rate to a range of 2.25% to 2.5%. Reuters titled the news “Fed jacks rates again, Powell vows no surrender in inflation battle”. Battling inflation and higher interest rate, this looks bad, right?

Not at all!

Just on the day, the US stocks rallied with the S&P 500 gaining 2.6% and the NASDAQ 4.06%. Why?

In mid of July, a lot of people were screaming that higher interest rates will kill the stock markets. I present the chart below in my monthly client’s Webinar and explained why rate hikes are not necessarily bad for the stock market. Since then, the stock market has rallied more than 5% in a matter of days.

Today, I will expand on the topic of interest rates and after which, you will have a better understanding.

This article is a continuation of the previously written two articles about inflation, and recession. Read Part 1 and Part 2 here.

Inflation is a scapegoat

First of all, I want to reiterate that inflation is a man-made process.

Contrary to popular belief, inflation is not the root cause of a recession. Rather, it is a manmade tool used as an “excuse” to raise the interest rate. And the purpose of raising interest rates is to reduce them later. This keeps the cycle going.

In short, a recession is used as a tool for wealth redistribution. It is not an easy-to-understand topic, but let’s just keep this in mind for now.

In Part 1 of this article series, I explained the reasons why we need to take a step back to evaluate statements exaggerating inflation and recession fears for viewership. The relationship between inflation, interest rates, and recession is intertwined and complicated.

Moving to Part 2, I explained how inflation and inflation expectations do not coincide. The CPI measures actual inflation. And inflation expectation is what the market anticipates inflation will be. When past inflation data is going up but inflation expectation is going down, it means we may have seen the peak of inflation.

Why Interest rate hikes are not meant to control inflation

If you agree for a moment that inflation is a manmade process, you will then soon realize that the so-called “controlling inflation” pronouncements by the government are not necessarily the real reason for an interest rate hike.

Inflation is the boogeyman excuse to carry out rate hikes. In other words, is it possible that the US intentionally lets inflation rise so it can raise the rates?

Thus, the next question arises: What’s in it for the US to direct the interest rates? I have explained this in my previous articles. In a nutshell:

• When you reduce interest rates to ease the monetary policy, money becomes cheaper. This cheap money creates an asset bubble.
• When the monetary policy is tightened, it bursts the bubble. And countries with a relatively higher rate tend to have a stronger currency, and they are in a better position to take possession of quality assets at a big discount.

That is why despite so many inflationary crises in the past, the US economy always emerges stronger and the stock markets always come back.

Let’s return to inflation: I have been consistently saying that an interest rate hike does not solve the inflation problem. Why not?

If you reason things out, we have been in an environment of reducing interest rates for the past two decades before the pandemic. But, did the economy face inflation or deflation? Deflation right?

While there have been minor increases in food prices and property prices have risen, the overall cost of living has become cheaper, thanks to technological advancements and globalization.

So if reducing the interest rate does not create inflation, is there any logic to the fact that hiking the interest rate will control inflation? It is a question worth pondering.

Why inflation should not be your biggest fear

Inflation is controllable as no market force is above politics.

As an investor, you need to remember that inflation data is a manmade measure.

It means that theoretically, it can be “massaged” if need be.

Remember how oil prices seemed to be reaching all-time highs and then mysteriously dropped? Who benefited and who lost?

Many people forget that the average inflation target is what will determine the direction of the central banks’ policies. This is what is known as “average inflation targeting.” For instance, the Bank of England and the US Feds are required to maintain inflation at 2% per year.

The developed economies can control inflation as they are considered economically stable. This is because developed countries like the UK, USA, and Singapore can “export” their inflationary excess through globalization.

As a case in point, the $150 jeans you bought only cost $20-35 to produce in India or China, remember?

Emerging economies are targets for inflation as they are financially unstable. While they need money to finance their economy, inflation is exported to them. This leads to a weakening of their currency and a growing foreign currency deficit. This in turn pressurizes their economy and weakens their currency. As a result, the overall economic system is endangered.

That is why it is no surprise to me when Sri Lanka declared bankruptcy. And I think some more will be coming.

The rate hike, not inflation is the driver of recession

Now you understand what matters is not the headline numbers. It is all about “inflation expectation.” If you believe inflation is going to erode your savings and bring you to a poorer financial situation, you are more likely to reduce your expenditures. Correct? Hence companies will invest less and economic activity will reduce. This in turn will create a vicious cycle.

Youtubers today keep talking about the big recession, which will lead to the stock market crash. This makes you hesitant to invest more in the stock market. Correct?

Have you ever considered who the real culprit behind stock market drops could be? Maybe, it is not the inflation numbers, but the rate hike itself.

I have talked about how a rate hike affects stock market valuation in this article. It explains why I have told my clients to stay away from high-growth stocks since the beginning of the year.

Political power is above all market forces

High-interest rates and monetary tightening help keep the US dollar as the desired currency.

We can see that the dollar index is almost at its 20-year peak.

But what is the most important political event this year? It will be the US mid-term elections.

High inflation may not be suitable for President Biden. Falling or sluggish stock markets would make the scenario even worse, and let’s not forget the US still has a lot of debts to repay. Continuing monetary tightening and higher interest rates will drain the US government’s cash flow pretty fast.

I suspect that the Fed is raising the rate rapidly so that they can reduce it again in the future. If that is the case, you need to be careful if you are betting on the interest rate moving in one direction – up.

So, when will the tightening end?

While many analysts argue that the Fed will raise interest rates at a faster pace, I think otherwise. In the following analysis, let’s stick with inflation and interest rates, leaving aside complicated factors like recession, foreign trade, and currency.

Arguably, the interest rate is just a relative number. The absolute number may not be so important anyways. The interest rate that is widely reported in headline news is the nominal interest rate. The government sets the nominal interest rate. The real interest rate, which we get after inflation adjustment should concern us the most, and it is what the Fed really cares about.

Real interest rate = nominal interest rate – the rate of inflation

We can use the TIPs yield as a tool to measure the “real interest rate.” Presented in the chart below, the real interest rates have been in negative territory since 2020. As of now, they have just reached zero point. This could mean that the current rate has achieved its objective of giving real positive returns. In other words, the Fed has managed to “control inflationary rates”.

If you asked me to guess, I would say the speed of the Fed’s rate hike will not accelerate but rather slow down in the coming months.

We were already in a recession

The word “recession” is only scary if you anticipate a recession. It’s actually not scary when you are in a recession.

People don’t look at the market rationally, most will act on market news and look for validation. If you act bearish while investing, everything will seem like bad news. If you are optimistic and protected, you will see the opportunities in the same statement.

The recession everyone has been dreading has been here since the start of 2020, when the pandemic started. Ask yourself the following questions:

• Is the state of the economy now better or worse compared to 2020?
• Does anyone you know have no food on the table?
• Are there a lot of people losing their jobs?
• Are there a lot of people failing to pay their mortgages?

If we are in better shape compared to the second quarter of 2020, maybe we have never actually gotten out of the recession until now. Would it be possible that instead of going down to a recession, we are on the path to recovery?

Let me summarize…

We should analyze the relationships between inflation, recession, interest rate hikes, and monetary policy tightening with these understandings:

• Inflation is a boogeyman used by politicians and governments. Inflation reduces purchasing power and therefore it is a convenient scapegoat for all economic problems.
• In addition, inflation is a tool used for wealth transfer. It works to “tax” the working class and enriches the wealthy capitalists at the expense of regular savers.
• I think there is very little chance that inflation in the US will grow out of control as long as the US dollar is still the world’s reserve currency.
• The data indicates that the inflation expectation is falling. I think this will allow for interest rate hikes and monetary tightening to slow down.
• The financial markets will continue to yo-yo around inflation, sometimes tapering, and with some interest rate movement. But you need to invest by looking beyond the hype and misinformation.

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