Expect US inflation to keep rising – that’s what the Fed wants

Markets are feeling uptight.

Lots of jitters in the last few days triple-digit drops on the Dow, restless, listless action you can tell when a market is feeling cranky.

At first, investors thought they could cope with the idea of the Federal Reserve raising rates in summer. As the next meeting approaches, they're not so sure.

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They needn't worry. Throwing a few more tantrums is all it'll take for the Fed to pat them on the head and fetch their cocoa.

The Federal Reserve is already well "behind the curve"

The Fed, says Jensen, normally begins to tighten interest rates when the unemployment rate falls below a certain level, dictated by the rather ugly term Nairu (the non-accelerating inflation rate of unemployment).

Put simply, if unemployment is above Nairu, then there's spare capacity in the economy if more people get jobs, you still won't get US inflation. But if unemployment is below Nairu, the labour market is getting tight, and pressure starts growing on wages to rise.

As with almost everything in economics, there's no genuinely scientific way to work this out, despite the spurious mathematical precision that accompanies any economic forecast. But in this case, the Fed believes that Nairu is around 5% and that's exactly where nationwide unemployment is sitting just now. In many States, unemployment is below Nairu, meaning the pressure is on.

That's coming through in wage data. Hourly earnings are rising at a decent clip. The number of new job openings is at its highest level this millennium. The fact is that, going by rate-rising cycles in the past, the Fed should be well into rate-hiking mode by now.

Indeed, says Jensen, looking at the data, "common sense would imply" that the Fed Funds rate should already be on its way to at least 5% or 6%.

So what's preventing them from doing it?

Well, I think you can guess. 5%? 6%? Wow. Can you imagine the state of the global economy if US interest rates were at that level right now? Or rather can you imagine the pain we'd go through to get to that level from where we are now?

How would people, companies and governments make their interest payments if rates were five percentage points higher than they are now? They couldn't.

And that's the problem in a word: debt. There's just too much of it. Which, as Jensen points out, is precisely why the Fed hasn't done much in terms of raising rates yet. "Low interest rates are the only way a massive default can be avoided."

So don't expect them to make any big moves anytime soon.

There are three ways out of a debt trap and two are out of the question

The first option is to pay the debt back, by outgrowing it. That's not an option today we can't hope to outgrow this level of debt.

The second option is to default on the debt. That's not really an option unless you're not an emerging market. Think about it people spent a big chunk of the last five years panicking about Greece defaulting. Greece is tiny in the global financial scheme of things. Imagine a major economy stiffing the global bond markets. We're talking the end of the financial system. So it won't happen.

That leaves us with option number three you repay the debt, but not with "real" money. In other words, you inflate your way out.

That's the option that developed economies want to go for. In fact, that's what monetary policy has been aiming for all this time. Get a decent inflationary fire going in your economy, and you can burn up that debt a lot quicker than most people imagine. That's the power of compounding for you.

So what happens next?

Well, you have to get the fire going. And if you've spent ages rubbing a few sticks together to ignite the dry tinder at your feet, the last thing you want to do is stop there. You don't reach for the bucket of water you fan the flames. You make sure it's roaring hot before you worry about how you're going to put it out later.

Monetary policy may operate with a lag, sure. Before the crisis in 2008, economists all said that once you raise or lower rates, you'll only feel the impact a year and a half to two years later. They don't seem so bothered about that these days (another "rule" of economics cast aside in the face of real-world experience).

So we can expect the Fed to stay behind the curve for as long as it can get away with. There will be a magic number I suspect it's getting on for at least the 4% mark before we get the first signs of a genuine inflation-fighting reaction.

I'll talk about the potential drivers of inflation in another Money Morning. But one thing's for sure a combination of low rates and rising inflation will make life very tricky for investors, particularly those looking to generate an income from their portfolios.

My colleague David C Stevenson who expects rates to remain low for decades, not years or months gave us his view on how to cope with this environment in this week's issue of MoneyWeek. If you missed it, click here to subscribe now.