Recently, the spotlight has been on the Federal Reserve (Fed) as it gears up for its anticipated decision on interest ratesA source from The Wall Street Journal, Nick Timiraos, has highlighted that the Fed is expected to approve a third consecutive increase of 0.75 percentage points at its upcoming meeting on WednesdayThis move is reportedly part of a broader strategy to tackle the persistent inflation that has been hitting the U.Seconomy hardFurthermore, there are indications that the Fed plans to continue raising the benchmark interest rate, aiming to maintain it above the 4% threshold in the coming months.

Since March, the Fed has been incrementally raising interest rates in response to ongoing inflationary pressuresHowever, despite these measures, inflation data reveals that as of August, the U.SConsumer Price Index (CPI) remains at a staggering 8.3%. This raises some critical questions for investors and economic analysts alike: Why have the Fed's rate hikes not effectively mitigated inflation? If the inflation rates continue to defy the Fed's attempts, why proceed with further hikes?

The crux of the matter revolves around the effectiveness of rate hikes in managing inflation

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In theory and practice within financial and economic principles, raising interest rates typically curtails inflation by escalating the costs of consumption and investmentThis, in turn, diminishes overall social demand, potentially leading to an excess of supply that might cause prices to decrease.

Historically speaking, data indicates a correlation between interest rates and inflation trends; specifically, since 1960, one can observe that increases in the Fed's rates generally precede declines in inflationNotably, most instances of falling inflation have been accompanied by rising interest rates.

Despite this, it's crucial to note that inflation often rises concurrently with interest rate hikesThis suggests a delayed effect where immediate responses to rate increases do not manifest immediately; therefore, the current instance of rising inflation in the U.S

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does not necessarily indicate a unique situation but rather aligns with historical patterns.

A significant reason for this delay is that the impacts of monetary policies take time to materialize in the economy, and the process is not instantaneousThe increases in market interest rates typically occur gradually, not sharply—in a manner that allows the economic landscape to shift over time.

Mechanism of Rate Hikes: Key Timing Considerations

When referring to rate increases, we primarily discuss the benchmark interest rates, which predominantly affect large financial institutions like commercial banksThese banks usually borrow at lower rates and lend to consumers

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However, an immediate reduction in demand is unlikely when rates are raised.

To illustrate, consider the reserve requirements commercial banks maintain with the central bankWhen the central bank sets a low-interest rate, banks are incentivized to lend out their funds to profit from differentialsIn contrast, if the central bank raises rates significantly, banks might opt to keep their reserves with the central bank, thus reducing the money available for lending.

Moreover, in the early stages of raising rates, the impact on consumer demand isn't immediateA critical point exists where the cost of deposits exceeds a certain threshold, compelling banks to tighten lending practicesFor example, if the Fed's deposit costs are at 2%, it needs to surpass that mark to motivate banks to cut loans

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Considering that the average deposit rates recently were around 1%, this pressure point only begins to exert influence once rates exceed approximately 2.5%.

Illustratively, if interest rates are projected to rise, both businesses and consumers might rush to secure loans at lower rates, potentially increasing loan demand during early rate increasesAs of now, the starting point of the U.Srate hikes commenced at 0%, with a considerable distance from the targeted rate of 2.5%. This temporal gap means that although rates are increasing, their actual impact on demand and inflation will not be immediately apparent.

Mechanisms of Rate Hikes: Influences of Money Supply

The cost of obtaining deposits mentioned earlier does not match the speed of rising interest rates because banks' average deposit costs reflect long-term averages, potentially leading to diversions in responsiveness

For instance, if a bank previously offered a 1% interest rate and suddenly increases it to 1.5%, its average rate over the past year will still reflect lower yield positions.

Furthermore, prolonged periods of low interest rates correlate with an increased money supplyIf the existing currency in circulation is already abundant, measures like tapering will result in minimal immediate impact, as removing a small amount from an overflowing glass does not alter its volume remarkablyIf the demand for money is significantly outstripped by supply, reducing the total monetary base will not significantly affect inflation rates.

In the lead-up to current rate hikes, the United States witnessed enormous quantitative easing, propelling the total money supply (M2) from approximately $16.1 trillion in March 2020 to $21.6 trillion prior to the hikes

This represents a staggering 34.2% increase within two years, leading to an excessive liquidity scenario.

Thus, when the Fed raises rates, M2 merely experiences a slight moderation, while the actual overabundance of currency limits the effectiveness of rate hikes on inflation reduction.

The Role of Rate Hike Expectations

Expectations surrounding interest rate hikes significantly affect financial marketsIf businesses foresee a bleak economic outlook, they tend to curtail investmentsSimilarly, consumers may limit spending in anticipation of lower income levelsIn financial markets, falling interest rates usually lead to declining valuations due to a compounded effect of both anticipated interest hikes and profit projections.

Consequently, such expectations often trigger downturns in stock market prices

However, interest rate hike expectations do not always correlate with such negative outcomesFor instance, from 2004 to 2007, a series of interest hikes resulted in a bull market, fueled by strong global economic conditionsConversely, in today's context—a backdrop of geopolitical tensions, ongoing pandemic challenges, and looming recession fears—anticipated rate hikes have led to downward pressures on valuations and profitability, significantly impacting markets.

Supply-Side Changes: Energy Crisis

In comparison to 2021, energy prices globally have nearly doubled in 2022. Although crude oil prices peaked in March, the disconnect between futures and current prices further complicates matters, with high energy costs driving persistent inflation since January of this year.

The sanctions imposed on Russia by the U.S

and Europe, coupled with decreasing dependence on Russian gas in Europe, have created significant supply disruptionsThe closure of major pipeline routes by Russia has exacerbated the situation, limiting energy availability in European markets.

Moving forward, energy prices are likely to remain elevated with fluctuating patterns, while underlying structural shortages are expected to persist, suggesting that significant declines won't materialize until sometime next year.

Another aspect significantly influencing U.Sinflation metrics is the baseline inflation rate from the previous year, which remained unusually low during the first half of 2021. While inflation broke through 4% as early as April 2021, prior months showed inflation levels of less than 1%. This low base is forecasted to shift dramatically as we head into the fall, causing an acceleration in inflation rates

Data from late 2021, with CPI figures at 6.2%, 6.8%, and 7% respectively, shows why forecasts expect inflation to soften as comparisons against previous figures become arduous.

Therefore, as we look towards October 2022, we may witness significant declines in inflation data due to the elevated baseline and deepening impacts of rising interest rates on economic demandAdditionally, supply chain fluctuations, ongoing commodity price adjustments, and heightened seasonal factors play crucial roles in shaping the upcoming quarterly results.

Conclusively, we are left with a nuanced and intricate economic landscapeWhile rate hikes are a critical tool at the Fed's disposal, their impact is tempered by a myriad of factors including time delays, expectations, and external economic pressuresThe fourth quarter may reveal pivotal insights into future trajectories, with anticipation for a window of improvement from October through November, yet caution advised for sustained economic growth thereafter amidst prevailing uncertainties.