Why Rate Hikes Won't Fix Inflation

You might be pretty upset about the Federal Reserve's recent decision about interest rates given the current rate of inflation, but today I'm going to show you why raising interest rates cannot solve the current inflation problem. We are facing today when you think about inflation, you might think about this chart right here, which shows the current inflation rate as reported by the Bureau of Labor Statistics at 3.4% historically, though, the word inflation used to refer to the expansion of the money supply and deflation referred to the contraction of the money supply. In fact, you can see right here. This is a picture from an old printed edition of a dictionary that defines inflation as an excessive increase of the currency of a country, especially by the issuing of paper money that is not backed by gold reserves. It was only the second definition that said a substantial rise of prices caused by excessive levels of demand or spending and or rising cost of production. Now people have understood for a very long time that if you expand the money supply too much, then that will cause an increase in prices that people do not like. This is nowhere near the earliest example. But if you go all the way back to the Revolutionary War, how they hyperinflated the continental currency in order to pay for the war that was such a destructive force that the framers of the Constitution specifically included language in the Constitution that would prohibit Congress from printing money. And that's why in article 1 section 8 clause 5 of the US Constitution. It says that Congress has the power to coin money that phrase coin money was not in the Articles of Confederation. They changed it in the Constitution to make sure that if the government was going to be involved in money, it was going to be metal and labeling the weight of that metal. So people have understood this relationship between the expansion of the money supply and its effects on prices for a very long time. And that's why those two terms eventually became synonymous. And now when we say inflation today, the definition today is a rise in prices generally across the board specifically in a basket of goods that most people tend to buy now because of this tight relationship between the money supply and prices that gave rise to an economic philosophy known as monetarism most well-known advocate of monetarism is of course Milton Friedman was famously quoted as saying that inflation is always and everywhere a monetary phenomenon. Now, there are many people who would put somebody like Milton Friedman up on a pedestal and say we need to follow that sort of thinking and that sort of ideology and let that sort of monetary policy dictate things in opposition to something like Keynesianism, but most people are not aware that when Milton Friedman said that inflation is everywhere and always a monetary phenomenon. He was saying that in respect to the Great Depression and the deflation that was happening. He was actually saying, hey, we should have just caused inflation by printing more money. And so Keynesians and monetarists are just two sides of the same coin. No matter which one you get, you always get more printing and more inflation. But here's the thing. The monetarists were wrong. This is a chart of the money supply in the United States. This accounts for all checking accounts, savings accounts, cash and brokerage accounts. Any cash that is easily accessible does not account for cash in retirement accounts since it can't be withdrawn and the money supply here only accounts for one side of the equation. The truth is that the price of anything the price of everything is always determined only by two things supply and demand money supply only represents the demand side of that equation and it completely ignores the supply side the production side the thing that is being bought now, technically there is a third factor that contributes to prices and that is government decree. So in the Monopoly on violence says, hey, this thing is going to cost more because anytime you do a transaction, we're going to charge you some money for it or they say, hey, only these people are allowed to do this certain type of transaction. These are forms of government decrees that will artificially change the price a real quick. 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For example, let's say the government says we're going to impose a 50% tax on employment. Anytime. There's an employment arrangement. Whatever the cost of that employee is we're going to charge you 50% of that across the board. That's going to make employment much more expensive independent of the supply and demand for employment and certainly it will also influence the supply and the demand which means that because it's more expensive fewer people will be able to afford to employ people as a side note. That means that if you want more employment and they should actually stop taxing employment so much that would increase the supply, but that's a story for another time. Okay. So the two main factors that contribute to the price of something by the supply and demand price of anything is always a constant auction between all the buyers and all of the sellers buyers represent the demand the sellers represent the supply. So let's go over some extreme examples so that you can see how this works at the extremes. It's the exact same way that it works for normal situations, but it's just easier to demonstrate by looking at the extremes for example number one. Let's say the supply of something overnight triples. And in this case, let's use the example of cars for every Toyota Corolla that exists. There are now three Toyota Corollas for every Harley-Davidson motorcycle. There are now three Harley-Davidson motorcycles for every Ford F-350 Super Duty. There are now three Ford F-350 Super Duty's you get the picture you go out in your driveway tomorrow and you see that each of your cars has multiplied. You used to have two cars in your driveway. Now you have six. Here's the thing though. You don't actually need six cars and you didn't have the coolest cars in the world anyway, and so it's not like you're super happy that you have six now, but you realize hey, I can profit here because I really only needed to to begin with now. I have four extra cars that I don't need. I'm just going to go sell them and raise some cash. But here's the thing you and literally every other person in the world are going to have the exact same thought and so if your car was worth $50,000 before you're going to go out there and say, hey, does anybody want to buy this for me for $50,000? There's not going to be a single buyer willing to pay $50,000 because there are so many sellers because the supply increased so dramatically. You're probably not going to get $40,000, $30,000, even $20,000. You probably get be lucky to even get $10,000, but guess what? You're actually still okay with that because you sell your four cars for $10,000 a piece. You just pocketed 40 grand. You're not really concerned about the fact that the value of your existing cars dropped overnight. You walked away with some extra cash. Now, if you're wondering why somebody would be willing to spend 10 grand on those cars when there are so many it's because as the price of something drops, it becomes profitable to use those things for other use cases. For example, 200 years ago oil was really expensive and hard to get. So it was only used for the things that you desperately needed it for like lighting oil lamps at nights that you had a source of light, but as oil became much much much more abundant and the supply increased dramatically over time the price went down and we found all sorts of other use cases for oil like literally making all of the things that we use and need on a daily basis and then using it for the transportation of all those things and using it to generate the energy that we need to make all those things. And so if the supply of cars tripled overnight, we would find so many more use cases for cars because they'd be so cheap might as well use them for those things and generally as the supply of stuff goes up. This is a very good thing for almost everybody because really it just means that more people get more of the things that we want and need. In other words, we don't have to sacrifice as much other stuff in order to get something in this case the car. So in summary when the supply of something goes up the price of that thing goes down. All right. Now, let's flip it move on to example 2 and let's say the demand for something triples and let's still use cars wake up tomorrow. You open up your phone. You see the headlines. You see the news for whatever reason the demand for cars has tripled. Maybe it's overseas buyers. Maybe it's immigrants. Maybe it's the government trying to take all the cars off the road. The the reason why doesn't really matter here. Let's just say the demand the number of people who want to buy a car or the number of cars that are trying to get bought triples overnight and this is real demand. This is not fake demand. So this is actual buyers trying to buy triple the amount of cars that buyers were trying to buy prior to today. That means immediately the price of the cars that exist will be bid up astronomically high because you still have to get to work. The truck driver still has to get his stuff from point A to point B bus driver still has to get the kids from home to school. And so there's a certain amount of supply that is locked up and cannot get sold the rest of the supply will realize. Hey, there are these desperate buyers that need to buy we can charge much much higher than what we could charge yesterday. So immediately most of the rental car companies will probably sell off their lots or at least half of them. All the dealership lots will be empty. Even if they do go for double or triple the price. That's what they're there for. They're trying to make a sale, but you might look out at your drive when you say, you know what we have two cars. Yes, we both need to get to work. But man, this is an opportunity to make $200,000 overnight on something that used to be worth $30,000. You're probably going to look at that and say, you know what we can sacrifice. We both have to make it to work in the morning. So we'll wake up earlier. I'll drive you drop you off and then I'll go to work and then I'll come pick you up after it's worth it because we're going to make so much money on going down to one car and because the demand is real. They need to buy these cars. They're bidding up the price. They're paying whatever they need to until they're able to get the number of cars that they need. So in summary, the demand for something goes up the price goes up now. We don't need to run through the examples, but it is worth mentioning that the opposite of both of these are true as well. So we talked about if supply goes up prices will go down. Well, if supply goes down prices will go up and we talked about how if demand goes up prices will go up. Well demand goes down prices will go down supply and demand are always in constant tension with each other buyers always want to pay the minimum possible price sellers always want to take the maximum possible price and only when an agreement on a price is reached will a transaction happen and supply and demand influence each other as well. So when demand spikes, let's say demand for cars spikes. Eventually production will ramp up because there's so much of a profit opportunity there if demand drops off of a cliff production will stop as well things that used to get made for every single household like radios and sewing machines and newspapers. The production of those things has declined significantly over the decades because the demand for those things has also declined significantly. So supply demand are always in constant tension with each other when they agree to an auto price transaction will happen and they also influence each other as well. One side gets much stronger and the other side will ramp up to meet it. Okay. So the question is how does the money supply play into all of this because you've heard inflation is always and everywhere a monetary phenomenon, but if it really is just supply and demand, how does the money supply play into this? We'll take a look at this spike in the money supply on money supply chart that happened in 2020 through 2021 over that time period the money supply increased roughly 40% going from 15 trillion up to a top of 21 trillion and a lot of the way that money supply was increased was by writing checks to individuals and organizations and businesses, which meant that suddenly overnight demand for anything skyrocketed when individuals got a check for $1,000 $2,000 in the mail. They lined up outside the Gucci store because suddenly they had purchasing power to increase their demand for something that they couldn't have before. And so when the money supply grows the demand for basically everything grows and when the money supply shrinks, that There's less purchasing power across the board, which means less demand. Imagine if you and everybody else woke up tomorrow and for every dollar that you had, you now have $10 very quickly. The price of everything would go up by about 10x alternatively imagine that tomorrow you woke up and for every dollar you had now you only have 50 cents and it's true across the board for everybody while there's not enough money floating around in the system to support all the transactions at their current prices prices would have to adjust lower for the new level of money supply. So the money supply represents demand for the entire system, but the money supply is still only one side of that equation. It's still only on the demand side. So hypothetically imagine this situation where you wake up tomorrow and the money supply has tripled for every dollar that existed. It now is $3 you had a hundred grand in your savings account. Now you have 300 grand in your savings account, but also imagine you won't wake up tomorrow and the supply of all of the stuff has also tripled. So for every iPhone that exists you look at your phone charger in the morning. Now, there's three iPhones sitting there. You got in your driveway. You had two cars. You now have six cars. You look down the street. You had one house. Now you have three houses. All of the food in your pantry has tripled overnight. Literally the entire world all of the wealth all the stuff triples overnight in addition to the money supply. The outcome of this would be that prices across the board would be relatively unchanged because if just the money supply increases on its own and nothing changes to the amount of stuff. Well, now you have more money chasing the same amount of goods and services. You have inflation if you just have an increase in the stuff, but the money supply stays the same. Now you have deflation because you have the same amount of money chasing away more goods and stuff. But if the total amount of wealth the goods and services that people want and need and the money supply both increase at a relatively consistent level, then you're not going to really have any change in prices. You might go and try and sell some of your iPhones that you have and everybody else is doing the same thing. So you'd think that would push down prices of iPhones, but now everybody has triple the money. And so that increase in overall demand would help sustain prices. This demonstrates the fact that again prices of everything are determined by supply and demand. The money supply is just the demand side. This concept doesn't really make sense to you. The best way to understand what would be going on here is to look at something like a stock split. Take for example, the stock Monster Beverage Corporation MNST the energy drink company. This stock has a market cap of 87 billion dollars and just about one month ago. They went through a two-for-one stock split their price per share was trading around 90 to $100 per share, but now it's trading at 44 $45 per share. So you think oh that means that the value of the stock went down because it was trading at a hundred now. It's only trading at like 50 but the number of shares that are outstanding double. So if you had one share before you now have to get one share that was worth a hundred dollars before now, you have two shares that are each worth 50. You have the same amount of wealth. So the market cap of monster never changed. It's still around 87 billion dollars. If all you did was change one of these things then you'd have a significant difference. If you only change the number of shares that existed or you only change the price of those shares that existed then you'd have a meaningful difference in the actual wealth. If you change both of those things in proportion with each other, there is no net change in wealth. So why is it that the Federal Reserve and most economists believe that if the Federal Reserve raises interest rates that they will be fighting inflation? Well, it's because of this chart and this chart. This first one is the total amount of household debt in the United States. And this one is the total amount of corporate debt in the United States. When you change interest rates, you change the cost of debt. The theory goes like this. If you can change interest rates and make interest rates go up and that makes it harder to get debt because it's more expensive. If it's harder to borrow that will decrease demand for borrowing that means less people less institutions will be borrowing money. More money will be used to paying off debt because more money is going to just paying down debt and less money is being borrowed for spending that will overall across the system decrease demand for everything. If decrease demand for everything happens again, like we discussed earlier prices would go down on the flip side. If the Federal Reserve lowers interest rates that makes it cheaper to borrow if it's cheaper to borrow institutions can borrow easier individuals can borrow easier. They can spend that money and that will increase spending which increases demand for everything across the board which increases prices. I as Yogi Berra like to say in theory, there's no difference between theory and practice, but in practice there is and that certainly applies here because that ignores the one side of the equation that I've been spending this entire video telling you about which is the supply side the production side because producers still have to make the things that people want to buy and if the Federal Reserve raises interest rates, it means institutions and individuals will save more money instead of borrowing and spending because it is too expensive to borrow more and spend more when a producer spends more they are investing in growing their business. They are increasing production because they are trying to sell more things the whole point but if borrowing becomes More expensive than more of their money has to go to service the debt less money can go to growing production because it's more expensive to make more things and if production of more stuff is too expensive than supply goes down and if supply goes down what do prices do they go up on the flip side if the Fed lowers interest rates. It makes borrowing cheaper when borrowing is cheaper. That means people invest less and save less and spend more businesses. Also when businesses spend more they are increasing production to make more stuff when businesses make more stuff. That means the price goes down. In other words raising interest rates when the US has a ton of debt can make inflation worse not better and cutting interest rates can actually help inflation come down. Now finally take a look at this chart of the money supply one more time. You'll notice that outside of February 2022 through September 2023 the money supply always only does one thing and that is go up and you'll notice over the past couple of years still it just goes up as the money supply goes up that is a force that helps demand stay elevated. That is one of the factors that influences prices. And so if interest rates go up, but the money supply also continues to go up now, you have two factors that are both contributing to higher prices production is getting more expensive and demand is staying elevated from the increase in the money supply. So given the decades-long history of the money supply doing Nothing but growing. I find it unreasonable to think that the Federal Reserve raising interest rates by a fraction of a percent is going to do anything to slow down the increase in the money supply and add on top of that the little cherry on top that we discussed way back in the beginning of the video, which is government decree the third factor that contributes to prices things like war are examples of government decree that take resources away from productive use and diverts them to literal destruction things like government spending government legislation that makes it harder for producers to produce. These are all things that are continuing to escalate right now contributing to growing prices that interest rates will not do anything to fix. If government decree makes oil three times as expensive the thing that literally contributes to the creation and the transportation of every single thing we use all day every single day and that will be a factor pushing prices up regardless of what interest rates to if through government decree everything coming into our country from another country becomes more expensive for a tax called tariffs that makes everything more expensive to produce. I hope at this point it is crystal clear that the Federal Reserve raising interest rates is going to do Jack diddly squat to inflation if they really truly want the inflation rate to come down meaningfully the very first lever is the money supply. You got to stop making this thing go up and stop printing. The second lever is less government spending in less government intervention that ship has sailed. We know none of that is going to happen. The third lever is actually lowering interest rates not raising interest rates have to make production of the stuff that people want and need cheaper. So if you care about increasing your wealth, the last thing you want is the Federal Reserve to start raising interest rates from here, but let's be honest since when did Federal Reserve understand or care about the way the economy really works one last note. If you're an active investor in your portfolio is not growing as fast as you'd like my team and I put together a completely free gift for you. It's called the portfolio stress test. All you have to do is answer some questions about your portfolio and your investing goals and then it will email you a custom blueprint that will help you fix the vulnerabilities in your portfolio that you'd maybe didn't even know were there. It's also going to give you access to all of my courses hundreds of hours of education strategies tactics on investing in trading that you need in order to fix your portfolio. Again, this is all completely free stuff. I used to charge a lot of money for your gift free access. It just go to heresy dot financial stress test. The link is in the description below felt the questionnaire plug in your information. I'll send you that custom blueprint. You can get started as always. Thanks so much for watching. Have a good day.