The Power Of Powell

To ensure a proper understanding of this piece I am going to assume that you have a good to loose understanding of the concepts of inflation, interest rate and the institution of the Central Bank. I however will introduce to you the fact that these three concepts are in a love triangle of some sort as they each significantly effect the way the other two respond.

Inflation is defined as a gradual loss of purchasing power reflected in a broad rise in the prices of goods and services over time. The inflation rate is calculated as the average price increase of a bundle of selected goods and services over a fiscal year. In essence, the money in your pocket (wallet, purse or bank account) loses value as it is unable to sufficiently pay for the same amount of goods and services this year as it did last year. Interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned. The interest rate on a loan is typically noted on an annual basis and expressed as an Annual Percentage Rate or APR. In essence, the lender, which is usually a bank charges you for borrowing money from them. Finally, the institution of the Central Bank, this is known A central bank has been described as the "lender of last resort," which means it is responsible for providing its nation's economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country's banking system from failing. However, the primary goal of central banks is to provide their countries' currencies with price stability by controlling inflation. A central bank also acts as the regulatory authority of a country's monetary policy and is the sole provider and printer of notes and coins in circulation. Time has proved that the central bank can best function in these capacities by remaining independent from government fiscal policy and therefore uninfluenced by the political concerns of any regime. A central bank should also be completely divested of any commercial banking interests. In the U.K. the central bank is called the Bank of England, In Canada, it is called the Bank of Canada, and in Nigeria it is called the Central Bank of Nigeria or the CBN. In most countries it is usually named “The Central Bank of x” as it is in Bahrain, Cyprus and Ireland or “The Bank of x” as it is in France, Estonia and Italy.

In the U.S. the Central Bank is known as The Federal Reserve, also known as The Fed (which shouldn’t be confused with the Feds a colloquial term for the police) headed by Mr. Jerome Powell. He is the person of interest we would be discussing today as unlike other heads of central banks, he is widely discussed and covered in the media. There is a lot of media chatter whenever he, and subsequently The Fed, have to make an announcement, especially towards the end of the fiscal quarter. This is because in these announcements, the Fed produces a report on their findings on the inflation rate and if they intend to raise, reduce or maintain the federal interest rate.

The Relationship Between Interest Rates and Inflation Rates

In the love triangle between interest rates, inflation rate and the central bank. I want you to consider the interest rate and inflation rate as a toxic couple who greatly oppose each other and the central bank as the mediator or therapist who always tries to find a middle ground. This is because the rise of one inversely proportionally causes the fall of the other. When the Fed raises rates, there is a direct consequential fall in the rate of inflation and when the Fed ‘cuts’ rates there is a direct and proportional rise in inflation. Interest rates and inflation rates are pivotal to macroeconomic stability. Central banks, like the Federal Reserve, leverage interest rate adjustments as a principal mechanism to manage inflation levels. This dynamic relationship influences consumer behaviour, investment decisions, and overall economic health.

When central banks raise interest rates, borrowing costs increase, making loans more expensive for consumers and businesses. This tends to dampen spending and investment, which in turn reduces overall economic demand. Lower demand can help to bring down inflation rates. Conversely, when interest rates are lowered, borrowing becomes cheaper, leading to an increase in spending and investment. This boost in economic activity can elevate demand, which may drive up inflation if the supply of goods and services does not keep pace with the increased demand.

The primary aim of central banks is to maintain inflation within a target range, typically around 2%. When inflation exceeds this target, central banks may raise interest rates to curtail economic activity and bring inflation back down. Conversely, if inflation is too low, they may lower rates to spur economic growth.

The Impact of Inflation on Interest Rates

Inflation expectations significantly influence interest rate settings. When consumers and businesses anticipate higher inflation, they demand higher interest rates to compensate for the expected erosion of purchasing power. Central banks, in turn, may raise interest rates preemptively to control these expectations and prevent inflation from escalating.

The distinction between nominal and real interest rates is crucial in this context. Nominal interest rates are the stated rates without adjustments for inflation, while real interest rates are nominal rates adjusted for inflation, representing the true cost of borrowing. The formula to calculate real interest rates is:

Real Interest Rate = Nominal Interest Rate − Inflation Rate

Real Interest Rate = Nominal Interest Rate − Inflation Rate

As inflation rises, nominal interest rates must increase to maintain stable real interest rates, ensuring that the lender’s purchasing power remains unaffected.

Historical Examples and Theoretical Insights

A notable historical example is the Volcker Shock in the 1980s, where the Federal Reserve, led by Chairman Paul Volcker, significantly raised interest rates to combat high inflation. This move successfully reduced inflation but also led to a severe recession, illustrating the powerful impact of interest rate adjustments on inflation control.

The Phillips Curve theory suggests an inverse relationship between inflation and unemployment, highlighting a trade-off where low unemployment can lead to higher inflation. Central banks must balance this trade-off when adjusting interest rates to maintain economic stability.

The Fisher Effect further elaborates on this relationship, positing that nominal interest rates are the sum of real interest rates and expected inflation. This theory underscores the importance of adjusting interest rates to reflect inflation expectations and preserve economic equilibrium.

Practical Implications for Policy and Decision-Making

From a policy perspective, central banks must calibrate interest rate changes carefully to avoid triggering excessive inflation or deflation. A balanced approach ensures long-term economic stability and growth.

For investors, understanding interest rates and inflation trends is crucial for making informed investment decisions. High inflation can erode the value of fixed-income investments, making equities and inflation-protected securities more attractive.

Consumers also benefit from this understanding, as it helps them make better borrowing and saving decisions. For instance, locking in low interest rates before anticipated inflation can lead to significant cost savings.

How Interest Rates Impact Stock Prices

Corporate profits are closely tied to interest rate movements. Many companies borrow for the short term with debt that resets each quarter. The interest on these loans is based on a rate index that mimics changes set by the Federal Reserve using the federal funds rate. The federal funds rate is the interest rate on short-term interbank loans and is typically what is being referred to when folks talk about "rate cuts.”

As a result, even the anticipation of a lower federal funds rate by the Federal Reserve can move other interest rates lower. This, in turn, helps boost general economic growth and corporate profits.

For example, inflation improved throughout 2023, falling to 3.4% by the end of December from 6.4% in 2022. This had the result of lowering a number of different key interest rates throughout the year. For example, the 2-year short-term Treasury yield, which is one interest rate the government uses to borrow money, was last seen at 4.9%, down significantly from its October 2023 peak near 5.24% – a period that coincided with the stock market's most recent lows.

This decline in interest rates occurred even as the Fed kept the federal funds rate at a range of 5.25% to 5.5%. Moreover, gross domestic product (GDP) excelled in Q4, growing at an annual rate of 3.4% according to the Bureau of Economic Analysis. And for all of 2023, the GDP growth rate was 2.5%. This indicated the economy was strong enough to withstand higher interest rates.

Yet at the end of 2024, futures traders were pricing in expectations the first quarter-point rate cut would come in March. In other words, the market's anticipation that the Fed would lower rates had a positive effect stock prices, since it assumes that a company's earnings per share and profits will rise as borrowing costs decline.

In effect, lower interest rates lead to higher price-to-earnings metrics and vice versa. But this is not the only way they help the market. 

Interest Rates And Wall Street

Many trading departments on Wall Street (i.e., Hedge Funds, prop desks at mainline brokerage firms, mutual funds, Private Equity  etc.) use extensive amounts of leverage to purchase their positions in the market. So lower short-term interest rates improve the costs of this borrowing activity. This, in effect, can help boost profits and potentially have a follow-on effect of increasing share prices. 

In addition to stocks, these positions can also include other leveraged securities markets. Think Treasury notes or secondary loan markets such as Collateralised loan obligations (CLOs). For example, the secondary market in CLOs, which are essentially bank loans of major corporations that trade on the market, becomes more liquid and profitable with lower rates. 

The bottom line is that interest rate movements can dramatically affect the borrowing costs of large Wall Street firms. By having lower borrowing costs, these companies can improve their profits. 

As a result, trading institutions tend to push up prices when interest rates and Treasury yields fall. The opposite also occurs when rates rise. But investors have plenty to be excited about this year given the market anticipates lower inflation and lower interest rates as a result. This will potentially lead to higher stock prices, higher bond and note prices (and lower yields).

Interest Rates And Private Equity

From 2012 to 2020, the global economy experienced an era of historically low interest rates, driven primarily by central banks' efforts to stimulate growth following the financial crisis of 2008-2009. These low rates reduced borrowing costs significantly, making it easier for companies to access cheap capital. This period, often characterised by the term "cheap money," allowed firms to finance expansion, operations, and new ventures at minimal costs. The ample liquidity in the financial markets spurred a surge in private equity deals and fuelled investments into new and innovative startups.

During this time, the proliferation of cheap capital led to the rise of numerous unicorn startups—private companies valued at over $1 billion. Startups such as Uber, WeWork, and Airbnb epitomised this era, attracting massive amounts of venture capital due to their disruptive business models and rapid growth potential. The abundant liquidity encouraged investors to bet heavily on high-risk, high-reward opportunities, often leading to valuations that far outstripped the companies' actual revenues or profitability. This environment of easy money allowed these startups to expand aggressively, capturing market share quickly and scaling their operations globally.

The influx of capital into these unicorns not only fostered innovation but also contributed to an overheated startup ecosystem. The ease of raising funds at high valuations created a culture where growth was prioritised over profitability, leading many companies to operate with significant cash burn rates in pursuit of market dominance. This approach, while fostering rapid expansion and technological advancements, also exposed the startups to greater financial vulnerabilities. The aggressive funding rounds and high valuations often led to a bubble-like environment, where investor expectations sometimes exceeded realistic financial performance metrics. Unfortunately, at this time I was getting a bachelor’s degree in Law rather than convincing venture capitalists that my startup was the next Facebook and they should get in on the ground floor.

The culmination of these dynamics led to a period of introspection and correction in the startup ecosystem. High-profile failures and financial struggles of companies like WeWork underscored the risks associated with the model of growth at all costs. As the economic environment shifted and interest rates began to rise, the availability of cheap money diminished, leading to a reassessment of startup valuations and business models. This transition marked a turning point for many unicorns, pushing them to adopt more sustainable financial practices and focus on achieving profitability to justify their valuations and ensure long-term viability.

It is important to note that the effect of the changes in interest rates are not immediate and usually takes about 2 or so years to come into full effect. For example, the rate changes that were instituted post the 2008 financial crisis was what led to the Startup Boom. Another example is the reduction in the interest rate that happened post-pandemic to discourage saving and increase spending to boost the economy that was emerging after the Covid lockdowns.

How Do Interest Rates Affect You

On the assumption that you aren’t a billionaire heir/heiress or a millionaire with a Private Wealth Manager and a portfolio of widely diverse assets, you may not be too concerned with the current interest rates however, it should be something that you should concern yourself with a little bit more. This is because the changes in interest rates have a near-direct impact on you and the things you do.

Changes in interest rates have a significant impact on the average citizen, affecting everything from borrowing costs to savings returns. When central banks, like the Federal Reserve or the Bank of England, adjust interest rates, they directly influence the cost of borrowing money. For instance, when interest rates are lowered, it becomes cheaper to take out loans and mortgages, which can encourage individuals to buy homes or finance other big-ticket items like cars. Lower rates generally make it easier for people to access credit, thereby increasing spending and stimulating economic activity.

Conversely, when interest rates rise, borrowing costs increase, making loans and mortgages more expensive. This can dampen consumer spending as people become more cautious about taking on debt. Higher interest rates can lead to higher monthly payments on variable-rate loans, including credit card debt, which can strain household budgets. For homeowners with variable-rate mortgages, an increase in rates can significantly raise monthly mortgage payments, potentially leading to financial difficulties or a reduced disposable income, which in turn can affect spending on other goods and services.

Interest rate changes also impact savings and investment returns. When interest rates are high, savings accounts, certificates of deposit (CDs), and other interest-bearing accounts offer better returns, encouraging people to save more. This can benefit those who rely on interest income, such as retirees. On the other hand, lower interest rates reduce the returns on these savings vehicles, which can be detrimental for savers. Lower returns may prompt people to seek higher yields in riskier investments, like stocks or real estate, which can have varying implications for personal financial stability

Furthermore, changes in interest rates can influence broader economic conditions, affecting job prospects and wage growth. Lower interest rates can stimulate business investment by reducing the cost of borrowing for companies, potentially leading to job creation and wage increases. Higher interest rates, however, can slow economic growth by making business loans more expensive, which may lead to reduced investment, slower job growth, and wage stagnation. Thus, fluctuations in interest rates can have a cascading effect on various aspects of personal finance and economic well-being for the average citizen.

In Conclusion

The love triangle of the three is more like a toxic relationship between the interest and inflation rates whereby the Central Bank is somewhat a paid third-wheeler who sides with one of the two as it best suits the economy at large. This is of course a gross oversimplification of these concepts and there are a multitude of areas that I never discussed such as how the Central Bank determines whether to raise, reduce or retain the interest rates and the factors they consider, nor how there are financial vehicles or products that are designed on making a profit through quantitatively analysing the data to predict the direction of the rate changes, IE, they make a profit or loss depending on the changes in the interest rate. However, I am certain that this gives a clear understanding of the fiscal responsibilities of the central banking system to significantly affect the economy by their decisions.