The Fed’s interest rates, the relationship with Bitcoin and inflation

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Inflation in the US is “galloping” and the Fed is in the process of raising interest rates to put the brakes on its continued rise, which is causing serious economic problems in the daily lives of millions of people.

This strategy on the part of the FED is dated. It essentially repeats itself, with the hope that it will again achieve the expected result.

The Fed's interest rates, the relationship with Bitcoin and inflation

The example of 1980

The last time the US suffered an unpleasant period of inflation was in the 1980s and the Federal Reserve, to put an end to it, proceeded to raise interest rates by up to three percentage points. This sharp and large increase in interest rates is about six times the rate seen in a more typical rate hike cycle, where the Fed usually moves by 0.25 percentage points.

Eventually then, the U.S. central bank’s main interest rate reached about five percentage points above the rate of inflation. As a result, this increase caused a sharp recession, but the goal was achieved: Inflation soon fell.

Today

Now, there is a similar gap between inflation and the Fed funds rate. Inflation soared to a new four-decade high of 9.1% last month.

Fed officials are worried, and for their part several US central bank governors have dismissed the possibility of a 1 percentage point rate hike, expressing a preference for a 0.75 percentage point increase.

Such a move would raise the federal funds rate to a range between 2.25% and 2.5%, which would still be at least 6 percentage points below the current rate of inflation.

Last month, Fed officials released their new quarterly economic forecasts. They expect the federal funds rate to be at 3.4%, while inflation is projected to be at 5.2% at the end of the year.

“We are as close to an emergency as far as inflation is concerned as we have been at any time in the last 40 years,” said Michael Feroli, chief U.S. economist at JPMorgan, and continued: “The only thing preventing it from being a full, unconstrained, emergency is that long-term inflation expectations which still look quite manageable.”

What an interest rate hike will mean for Bitcoin

The dynamics are also being closely watched in Bitcoin (BTC), in part because the price performance of the largest cryptocurrency per market cap has recently correlated with US stocks.

Faster interest rate hikes will make bonds more attractive to investors. Higher borrowing costs will impact corporate earnings and slow the pace of investment, which could affect stock prices.

Dan Morehead, CEO of Pantera Capital, recently wrote that the difference between inflation and the federal funds rate is greater than at any other time in history. The rate is currently where it was before the coronavirus pandemic, when inflation was at 2.3%.

On Friday, a University of Michigan survey showed that consumers see inflation running at 2.8% over a five-year horizon, down from an expected 3.1% in June.

The Fed’s admission

However, currently inflation is still running at a four-decade high and Fed chairman Jerome Powell has admitted that the US central bank underestimated the pace of consumer price increases and was wrong to call it “transitory”.

He also said repeatedly that the economy, thanks to a very hot labor market, is very strong, which is why many market participants predicted a 100 basis point (one percentage point) increase in July.

The Fed’s current goal is to get the federal funds rate to a longer-term neutral rate of 2.5%, however minutes from the last FOMC meeting show that officials are planning rate hikes that will take the rate to 3.4% this year.

This strategy will not work

Vincent Reinhart, a former Fed official who is now chief economist and macro strategist at Dreyfus and Mellon, pointed out that it is difficult to see how the Fed will reduce inflation if the federal funds rate remains negative throughout the year, as shown in officials’ forecasts.

And in explaining the above Reinhart noted that the Fed risks violating the Taylor Principle. According to the Taylor Principle, the real interest rate should rise “more than one-to-one” when inflation rises. However, the interest rate is currently negative because it is lower than inflation.

“That’s one complaint you can have about the Federal Reserve right now,” Reinhart said.

According to U.S. estimates, if all goes according to the Fed’s plan, inflation will slow significantly in the fourth quarter, and if officials’ forecasts prove accurate, the federal funds rate will be as high as 3.5 percent by the end of the year.

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