Why is the US inflation level still higher than the central bank's target after implementing the most aggressive rate hike in generations by the Federal Reserve? Why did the interest rate hike not take effect as scheduled? In response, a well-known person in the US bond market put forward an opinion contrary to orthodox theory: the Federal Reserve needs to cut interest rates in order to further reduce inflation as scheduled.

“Only when the Federal Reserve cuts interest rates can reduce inflation”

Normally, when inflation becomes an issue in the economy, the Federal Reserve raises interest rates to deal with inflation, which actually increases borrowing costs for US businesses and consumers to curb demand. The goal is to stabilize prices by encouraging increased savings and reduced spending, thereby slowing economic activity.

This orthodox monetary policy usually works well. What is controversial is that over the past few years, we have all witnessed Federal Reserve Chairman Powell's success in fighting inflation. Powell raised the federal funds rate from near zero to between 5.25% and 5.5% between March 2022 and July 2023. Subsequently, borrowing costs have risen across the US, helping to curb a soaring real estate market, which is a major source of inflation; causing the stock market to experience at least moderate deflation in 2022; and limiting consumer inflation expectations (which may evolve into self-fulfilling predictions). The inflation rate then fell from a 40-year high of over 9% in June 2022 to 3% in July of the following year.

Since then, although high interest rates have continued to weigh on the US economy, inflation has failed to fall to the Federal Reserve's 2% target and has been hovering between 3% and 3.5%. Some economists believe that the economic slowdown is the result of Powell's decision to keep interest rates stable for nearly a year, rather than implementing more rate hikes. But Rick Rieder, BlackRock's chief investment officer for global fixed income and head of the global allocation team, has a different theory, which seems contrary to orthodox economic theory. In an interview, Rieder believes that the Fed's interest rate hike is not a cure for the current illness of the US economy. He said: “It is currently unclear to me whether higher (interest rates) will help lower inflation or actually boost inflation.”

This veteran who has worked at BlackRock for 14 years believes that the Federal Reserve may need to change its strategy and choose to cut interest rates to counter the remnants of inflation. He manages $2.4 trillion in assets at BlackRock and is one of the main voices in the bond market. This is all because many low-debt, cash-rich consumers and businesses — particularly baby boomers and Fortune 500 companies — are actually profiting from high interest rates, Rieder notes.

Rieder explained that the savings boom driven by US government spending and rising asset prices in the COVID-19 era have made these large businesses and wealthy consumers net lenders rather than borrowers. Now, with higher interest rates offering generous returns to anyone with cash, the private sector's lending position has created a steady stream of inflationary revenue in a key sector of the economy.

Rieder added: “If you think about what has happened in the past few years, you'll find that there has been a huge shift from the public sector to the private sector. Companies pay off their debts, and individuals deleverage, and you have a dynamic where you have large amounts of savings and capital in money market funds. Now, if you look at service-level inflation, part of the reason is that these companies and individuals have too much revenue flowing through the system; in fact, it's being recycled.”

Not long ago, Rieder's hypothesis — higher interest rates could benefit a select portion of the population, thereby increasing inflation — was considered unconventional, at least on Wall Street. But now, according to the minutes of the May 1 Federal Open Market Committee (FOMC) meeting, even Federal Reserve officials are beginning to consider “the possibility that the impact of high interest rates may be less than in the past.”

Here's why some of Wall Street's top economists and the Federal Reserve's best economists are changing their views on the impact of high interest rates on the US economy:

Reason 1: Baby boomers bring a “consumer boom”

The so-called baby boomers refer to Americans born between the end of World War II in 1946 and 1964. The number reached 76 million, accounting for one-third of the US population at the time. As the largest generation born in US history, baby boomers are the mainstay of the US economy in recent decades, and have also accumulated extremely impressive wealth. Currently, most of them are between the ages of 59 and 77, and have retired or are close to retirement age.

Rieder pointed out that the astonishing wealth and desire to spend among the elderly in the US is one of the reasons why it is difficult for the Federal Reserve to control the key service sector inflation component of inflation. Their new role as lenders has boosted this in an environment of rising interest rates.

Service inflation — particularly in core services other than housing, including prices for health care, recreation, tuition, and insurance, but not housing or energy — has been one of the areas the Federal Reserve is most concerned about for many years. As early as November 2022, Powell stated that this indicator “is probably the most important category for understanding the future evolution of inflation.” There are several reasons for this outlook. First, the service sector accounts for more than 70% of the US economy. Second, indicators of inflation in the core services sector after excluding housing factors are usually used to measure so-called cost-driven inflation, which is driven by wage or wealth growth, and is used to observe whether price increases are entrenched in the economy.

Now, Rieder believes that many wealthy people, usually older Americans, tend to spend more on services, and they may have inadvertently stopped the anti-inflation situation in this key sector of the economy. “People over 55 are now big consumers — this is actually pretty amazing,” he said. In particular, middle- and high-income earners (seniors) now have large savings. This will directly flow back into consumption, including highly sticky sectors such as entertainment, leisure, and healthcare.”

In Rieder's view, the US Bureau of Labor Statistics's consumer spending survey shows that older Americans tend to spend more money on recreation, health care, and other service categories, and the Federal Reserve is trying to fight inflation in these areas.

In 2022, Baby Boomers spent an average of $3,476 on entertainment, while Gen Z spent about half that, just $1,693. Similarly, Baby Boomers spent an average of $7,116 on healthcare in 2022, compared to $4,156 for millennials and just $1,560 for Gen Z. “In these areas, what you're seeing is service-level inflation, so it's hard to bring it down,” Rieder said.

America's elderly are also in an advantageous position with wealth and debt, and can continue to spend in these critical service sectors, which can drive up inflation. According to the Federal Reserve's consumer finance survey, by the end of 2023, Americans had a total of 147 trillion dollars in assets, but about half of that wealth — 76 trillion US dollars — belongs to the baby boomers, and the silent generation has another 20 trillion dollars. As Ed Yardeni, a senior economist and market strategist who runs Yardeni Research, said in a recent report: “They are the richest group of older people ever.”

Older Americans are not only rich in assets, but they also have far less debt than other generations, which means that these new and well-known private lenders have a steady stream of spending capital in the face of rising interest rates. Census data shows that by 2023, although Baby Boomers have far more assets, their consumer debt is only $1.1 trillion, while Gen X and Millennials have $3.8 trillion in consumer debt.

Similarly, by 2023, baby boomers held $2.7 trillion in home mortgages compared to $9.9 trillion for millennials and Gen Xers. According to a Redfin survey, about 54% of baby boomer homeowners also own their own homes entirely, compared to about 40% of the total population. Yardeni notes that many American seniors also have the chance to refinance their mortgages in 2020 and 2021 with record low interest rates.

Most importantly, most baby boomers have now completed their kids' college tuition; many have just received an increase in social security benefits; and others are finally getting a real return from their savings, leaving them with enough money to spend. Rieder believes all of this is good for the elderly and wealthy Americans, but this could be an issue with service sector inflation.

When it comes to the impact of high interest rates on the rich, it seems that at least some Federal Reserve officials agree with Rieder. At the FOMC meeting on May 1, several participants pointed out that “the financial situation appears to be favorable to wealthy families” in the first quarter.

Reason 2: Businesses with plenty of cash are profiting from higher interest rates

It is not only the rich who are changing the way interest rates affect the US economy, but also often large American companies. There is evidence that until the Federal Reserve raised interest rates, some of America's largest companies were able to repay their debts or lock in long-term low-interest debt. Today, for the first time in more than 10 years, these companies are reaping impressive returns by issuing additional cash due to rising interest rates. For Rieder, all of this meant “it's unclear whether higher interest rates will actually cause more inflation.”

Rieder isn't the only one making this point either. In August 2023, Societans strategist Albert Edwards, known for lamenting the rise in greedy inflation during the COVID-19 pandemic, wrote a report describing what he called the “craziest macro chart” in history. The chart below shows that despite rising interest rates, net interest payments by US companies fell sharply in 2022 and 2023.

According to orthodox economic theory, higher interest rates should increase borrowing costs, so what happened? It turns out, as described by Rieder, many companies were able to ease their debt burdens or lock in low-interest debt until the Federal Reserve raised interest rates to fight inflation. (The Federal Reserve's now notorious “temporary” call to postpone the long-term anticipated rate hike for 2021 has given many companies time to prepare for a higher interest rate system.) At the same time, many of these companies became lenders after interest rates rose. Edwards said the end result was that large companies became “net beneficiaries of high interest rates.”

Edwards wrote in an August 2023 report: “Higher interest rates increased last year's profits by 5%, rather than dragging down profits by more than 10% as usual. Interest rates simply aren't as effective as they used to be.”

Edwards believes that stable interest rate increases provided revenue for large companies and helped the US avoid a recession by increasing corporate profit margins and consolidating the labor market last year. But now, Rieder warns that this trend may also intensify the difficult battle against the remnants of US inflation. After all, creditors have done a pretty good job, and “the private sector is now a creditor.” And baby boomers, who have plenty of money on hand, have also reaped their investment in these large companies, and the US stock market, which has repeatedly reached new heights, is the best path.

Whether to cut interest rates or not, Rieder still sees an opportunity in the fixed income market

Given Rieder's views on how high interest rates affect inflation, it's no wonder he believes the Federal Reserve will cut interest rates this year. But even if the Federal Reserve doesn't agree with his views on the impact of high interest rates on the economy, Rieder still believes there is enough evidence that they should cut interest rates. There has been “some mild weakness” in employment and consumer spending, and inflation, although still high, has remained stable. Rieder said, “I just think the Federal Reserve wants to see a window period where inflation does not accelerate. If you have months of data, you should have enough data for them to start cutting interest rates.”

Rieder said he expects to cut interest rates by September. The timing is definitely favorable for BlackRock Flexible Income ETF (BNC), the first actively managed ETF he launched in July 2023. BINC is a diversified bond and yield ETF that aims to provide customers with high-yield bonds with low volatility.

The launch of this ETF seems to have taken timing into account. Bond prices tend to rise as yields fall, which means that interest rate cuts will support Rieder's holdings — marketing materials from March 2023 even mentioned “the Fed's interest rate hike cycle may be over,” which “creates more opportunities for fixed income.”

But Rieder said that even if the Federal Reserve doesn't cut interest rates immediately, he believes bonds now provide an attractive opportunity for investors seeking stable returns. “There are benefits everywhere,” he said. As a result, you can continue to hold higher quality (bonds) than before.”

As inflation remains high and forces the Federal Reserve to keep interest rates at a high level, Rieder believes that the current market is a golden opportunity for bond market investors to lock in higher yields. If interest rates do fall, they may also be able to profit from some capital appreciation. “For me, this was an incredible gift,” Rieder said. As inflation remains at current levels, it is less expensive for us to buy credit assets than it should be.”

Editor/Jeffrey