Banananomics: Promising Economic Levers Are Helpless

Promising Economic Levers Are Helpless

The most important question for the U.S. economy in 2024 is whether and when the Federal Reserve will cut interest rates.

Inputs that matter: With so much media coverage, one may expect the relationship between interest rates and inflation to be thoroughly understood by the economic establishment.

• However, over the past two years, reality has looked nothing like the theories found in economics textbooks.

• The uncomfortable truth is that no one knows how interest rates work or even whether they work—not the experts who study them, the investors who track them, or the officials who set them.

The opportunity: For example, a Bloomberg economics model once forecasted a 100% probability of recession by October 2023, but that never happened.

• Instead, inflation fell from 9% in June 2022 to about 3% by the end of 2023.

• The Fed raised rates, and inflation fell—but the other steps in the chain reaction never happened.

Zoom in: The belief that raising interest rates is the cure for inflation is largely unproven.

• The theory begins with the Fed increasing the federal funds rate—the interest that banks must pay to borrow money from one another—which forces them to charge more for consumer loans.

• When borrowing money becomes more expensive, fewer people will buy homes or finance cars, and companies will slow their investments.

• In short, everyone starts spending less money.

Between the lines: According to Reuters, U.S. monthly inflation was unchanged in May as a modest increase in the cost of services was offset by the largest drop in goods prices in six months.

• "It helps the argument that inflation is looking better-behaved, which may open the door to interest rate cuts later in the year," said James Knightley, chief international economist at ING.

• The price of gasoline and other energy goods dropped 3.4%.

• The cost of services increased 0.2%, lifted by higher prices for housing, utilities, and healthcare.

Follow the money: Inflation is still too high for reasons no one fully understands.

• For the central bank, interest rates are like those of chemotherapy. 

• They might have horrible side effects. 

• They might not even work. 

• But they're a lot better than taking your chances with the cancer of inflation.

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