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Peter Morici: The neutral interest rate is 6%—much higher than Fed policy makers admit

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The Federal Reserve quickly raising interest rates has disrupted stock and bond markets and multiplying default risks for corporate and developing country debt. This too shall pass but the era of terribly low inflation and interest rates is over for a long time.

From the end of the global financial crisis until COVID, inflation risks were low—thanks to businesses optimizing supply chains and cheap labor and energy in places like China and Russia. Chasing 2% inflation, central banks kept interest rates historically low.

The world has changed and so have the trade-offs between inflation and unemployment and the likely neutral rate of interest—the federal funds rate
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that is neither accommodative nor restrictive.

President Joe Biden curbing domestic drilling and pipeline development—while the West simultaneously boycotts oil from Russia and Iran and can’t build and deploy electric cars fast enough—compels that petroleum prices
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 remain volatile and a potential source of inflation until at least the end of this decade.

Climate change driving droughts and floods and limited access to Russian and Ukrainian agricultural commodities and fertilizer will push agricultural prices higher, instigate shortages in the developing world and keep groceries a factor in inflation for several more years.

Housing prices and rents may go through a correction but longer-term, real estate values are a function of the cumulative stock of units built more than the pace of new construction.

Higher interest rates
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and resulting slower economic growth may push down demand, home prices and slow rents increases in the near-term, but slower construction of new units will exacerbate home and apartment shortages after the economic slowdown or recession ends.

Bottom line: tighter monetary policy in 2022 manufactures more housing inflation in 2024 and beyond.

Chronic shortages of lithium will make electric vehicles much more costly. The unreliability of solar and wind and cost of nuclear and fossil-fuel backups to ensure a reliable grid will make electricity and driving those vehicles more expensive.

The work-from-home solution requires larger dwellings and more pressures, not fewer, on scarce developable land.

Together energy, groceries, autos and housing account for 57% of the consumer price index.

The skills shortages facing American businesses won’t abate soon. High schools focus too much on college prep and too little on vocational training alternatives. And the controversy over critical race theory in school curriculums and the damage to student progress resulting from COVID shutdowns will distract from reforms in high-school goals and curriculum to better serve career development.

The lesson from Iran, which now suffers street unrest, is underarming Ukraine and relying on sanctions will not fundamentally alter the regime in Moscow or free up Ukrainian and Russian agricultural commodities and petroleum anytime soon.

In China, President Xi Jinping has decided to appoint himself the ayatollah and president at the same time. He is bent on wiping out feminism and homosexuality to promote traditional marriage and child bearing, tightening controls on thought and speech by filtering the internet and through an Orwellian system of domestic surveillance of ordinary citizens, neutering the power of high-tech and private entrepreneurs and reasserting state planning and the centrality of ideological conformity—albeit through an unsettling resurrection of the kind of national socialism that directed pre-World War II Germany and Japan.

That’s not what made contemporary China a modern economy, a global leader in EV batteries and solar panels and permitted TikTok and WeChat to lap Meta
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and Twitter. These days businesses are hedging their China bets, and that diversification means the era of driving down U.S. prices with Chinese imports may be waning.

Inflation averaged about 4% for 10 years after Paul Volcker brought it down from double-digit levels in the early 1980s. We are likely headed to no better without more assertive measures to end the war in Ukraine, free up domestic drilling and pipeline construction, concede the transition to electric vehicles will be gradual, fix our schools, and free up urban building sites.

None of that is in the DNA of Biden, his West Wing advisers or the hard left of the Democratic Party.

To get inflation below 4% we likely would have to endure unemployment of higher than 6% and similarly high interest rates until we get new, less-ideological leadership.

According to the most recent dot plot, Fed policy makers see the long-run federal funds rate settling at about 2.5% but given these inflationary pressures, a rate equal to the sum of their 1.8% projected long-run real rate of growth plus inflation at 4% would put the neutral rate of interest closer to 6%.

Equity investors should not panic. Once the excesses induced by the terribly low interest rates of the 2010s are squeezed from the system, business can adjust to this environment, enjoy decently growing profits, and stock prices
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should recover. 

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

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