Interest Rates and Inflation

The Fed is trying to fight inflation and to reduce it by raising interest rates (I’m omitting the Progressive-Democratic Party-controlled Congress’ and White House’s countervailing profligate spending that fuels inflation). There are growing questions regarding how fast the Fed should raise rates after its last few .75% rate increases. As The Wall Street Journal noted, that debate tends to obscure a related and more important argument over how high rates need to go in the end in order to halt the current inflation (and reduce inflation to a more manageable and historically targeted rate of 2%).

Some officials have argued for slowing the pace of rate rises after this week’s meeting. But the debate over the speed of increases could obscure a more important one around how high rates ultimately rise.

But the discussion as a whole misses another factor impacting market interest rates: the private—nonbank—market in lending. These entities are private individuals or private companies outside the traditional financial industry—banks, investment banks, credit unions—who extend loans (in the context of this post) to companies. These private lenders mostly lend into the housing industry (which is falling on interest rate-driven hard times), but in today’s environment they’re branching out.

The question of private lending matters here because in order to make the loans—and so to make money—the private lender must offer terms more favorable to the borrower than the banks offer (keeping in mind that what banks can offer is heavily influenced by the Fed). The private lender’s terms can center on a variety of parameters—loan period, collateral required, and so on, as can the bank’s—but the primary parameter is the interest rate demanded. That private lender rate must be lower than the bank’s rate, or the borrower will stay with the bank.

The private lenders’ lower rates mitigate the Fed’s efforts to fight inflation with rising interest rates. There are two aspects to this conflict. One is that rising interest rates are intrinsically inflationary—they drive up the cost of money and so of prices. Private lender competition through interest rates would seem to be counter-inflationary. However, the inflationary impact of rising rates takes time to develop, while the counter-inflationary impact of rising rates is relatively immediate: that immediate increase in the cost of money reduces producers’ nearby demand for goods and services, which reduces cost for producers’ goods and services, and that percolates through to reduced consumer prices—the inflation consumers face—relatively quickly.

The other aspect is how large a role private lending plays in the loan/borrower market, and so how much conflict there really is between the Feds’ need to raise rates to kill excessive inflation and the private lenders’ playing into this new market niche of bank vs private lending with lower rates. That’s unknown, so far; the expansion of private lending is a new, investment technology- and communications technology-driven phenomenon.

And this whole discussion, including mine, doesn’t account for venture capital investing, including SPAC investing, which is glorified lending: these entities invest in small (usually) companies. Usually, the investments are with a view to the company growing and with that value increment, the venture capitalists and the subgroup that is SPACs get their investment back.

But often, those investments are loans, or have serious loan components, with the company as collateral: the investors get the company if the loan isn’t repaid, or by design of the loan component, the repayment is the company. Such venture capital “lending” dilutes the lending market as a whole, and so tends to weaken the impact of Fed actions to the extent that dilution grows.

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