Pain ahead.

Jerome Powell, Fed Chair: 

     "We have got to get inflation behind us. I wish there were a painless way to do that. There isn't."

Candidates complain about inflation. That's easy. They don't advocate solutions. They are hard.

Inflation is real. The Federal Reserve has a tool to reduce it. They pull money out of the economy and raise interest rates. This reduces overall demand for goods and services, so prices fall. "Reduce overall demand" sounds clean and simple. It is impersonal. "Demand" describes an economy. The real world is made up of people. 

The Fed just raised interest rates another 0.75%. The era of zero interest rates is gone. Zero interest rates distorted financial markets. People made investments that only made sense if money were free to borrow, but in reality wealth--capital--has value, so the economy adjusted to a false reality. Zero interest rates caused people who wanted safe income to look in risky places to find it. Zero interest caused asset bubbles. The Fed is doing what needed to be done years ago. 

Higher interest rates means businesses pay more to finance supplies and inventory. Most construction is financed, so the cost of building or improving factories goes up. The cost of building or purchasing houses goes up. People typically borrow money to buy cars, so the cost of cars goes up. We get slow-downs and layoffs. These trickle through the entire economy.

Rising unemployment is the consequence and the measure of the Fed's success. Powell called it, "softening of labor market conditions." Let's get real. It means people lose their jobs. That makes poor people poorer. Their distress sends a signal felt throughout the economy. People see others getting laid off and they recalculate their own marketability.

Higher interest rates send a signal to businesses and the people who own them. In a slowing economy the business is less likely to raise prices to compensate for the higher interest rate costs. Profits go down, so the less-profitable business is worth less. Moreover, businesses are valued based on the presumed stream of future profit and income. That income is discounted back to the present. Future money is worth less in a 10% interest rate environment than in a 1% environment. Stocks tend to go down when interest rates go up.

The stock market going down is another consequence and measure of Fed success. Investors not only are less rich measured by their account statement, they feel less rich. They might own 3,000 shares of Facebook in their 401Ks. A year ago the shares were worth over a million dollars. Today they are valued at less than $500,000. Even if the money in a 401k is not going to be spent anytime soon, the lower value changes psychology and behavior. They feel poorer and spend less.

It is the same with home prices. Rising interest rates have reversed the housing boom. People feel more free to spend money if their home is priced at an all-time high and can be sold immediately. With houses sitting unsold on the market, homeowners are more cautious.

There will be a lot of squabbling over definitions. Is the economy good or bad? If unemployment rises, is that failure or back to normal? Are we in a recession, or just a slowdown? Are we in free-fall or is the economy already on its way back up? Republicans will define things as bad, complicated when the governor of a state is a Republican, who will then say the economy of their state is great and the envy of the country. 

What isn't definitional squabbling is that the Fed will try to make Americans poorer, so they will spend less freely and work harder to keep the job or customers they have. That is the simple on-the-ground reality. The Fed's goal is to make workers more nervous, entrepreneurs more cautious, and owners of stocks feel lousy when they look at their account statements. Candidates will talk about the problem, but not the real-world solution. The solution is pain. 

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