This is a story about how interest rate hikes are supposed to work, and why they might not be working as intended right now—at least according to one of the bond market’s biggest names.
Typically, when inflation becomes an issue in the economy, the Federal Reserve raises interest rates to fight it, effectively increasing borrowing costs for businesses and consumers nationwide. The goal is to stabilize prices by incentivizing more saving and less spending, which slows economic activity.
This orthodox monetary policy usually works quite well. Debatably, we’ve all witnessed its success over the past few years in Federal Reserve Chair Jerome Powell’s battle against inflation.
Between March 2022 and July 2023, Powell raised the Fed funds rate from near-zero to a range between 5.25% and 5.5%. The subsequent rise in borrowing costs across the U.S. helped to stall the once-surging housing market, a key source of inflation; led to an at least mildly deflationary stock market rout in 2022; and put a lid on consumers’ inflation expectations (which can devolve into self-fulfilling prophecies). In turn, year-over-year inflation sank from its four-decade high above 9% in June 2022 to just 3% by July of the following year.
However, since then, despite the consistent economic drag from higher interest rates, inflation has failed to drop to the Fed’s 2% target, sticking in a range between 3% and 3.5%. Some economists argue this stall is the result of Powell’s decision to hold interest rates steady for nearly a year now instead of implementing more rate hikes. But Rick Rieder, chief investment officer of global fixed income and head of the global allocation team at BlackRock, has a different theory that seems to go against economic orthodoxy.
In an interview with Fortune, Rieder argued the Fed’s interest rate hikes are the wrong medicine for the economy’s current disease. “It’s ambiguous to me today, at best, whether a higher [interest] rate helps bring down inflation versus actually contributes to it,” he said.
The 14-year BlackRock veteran, who oversees $2.4 trillion in assets at the world’s largest asset manager and is known as one of the leading voices in the bond market, argued that the Fed may need to change its strategy and opt for rate cuts in order to fight the last remnants of inflation. And it’s all because many low-debt, cash-rich consumers and businesses—particularly baby boomers and Fortune 500 giants—are actually profiting from higher rates.
The government-spending–driven savings boom and asset price appreciation of the COVID era enabled these large businesses and well-off consumers to become net lenders, rather than borrowers, according to Rieder. Now, with higher interest rates offering a hefty reward to anyone with the cash to lend, the private sector’s lender status has created a steady, inflationary income stream in a key part of the economy.
“If you think about what happened in the last couple of years, the public sector made a huge transfer to the private sector. Companies termed out their debt, individuals de-levered, and you have a dynamic where you have huge amounts of savings and money in money-market funds,” he explained. “Now, if you look at service-level inflation, some of it is because you have so much income flowing through the system with these companies and individuals that it actually gets recirculated.”
Not long ago, Rieder’s hypothesis—that higher interest rates may be benefiting a select segment of the population that is then boosting inflation—would have been considered unconventional on Wall Street, to say the least. But now, even Fed officials are beginning to consider “the possibility that high interest rates may be having smaller effects than in the past,” according to the minutes of the May 1 Federal Open Market Committee (FOMC) meeting. Here’s why some of Wall Street’s top minds, and the Fed’s best economists, are shifting their thinking about the impact of higher interest rates on the U.S. economy.
A baby boomer economy
Rieder pointed to older Americans’ striking wealth and desire to spend, which has been bolstered by their new role as lenders in a higher interest rate environment, as one of the reasons the Fed has struggled to control the critical services component of inflation.
Services inflation—particularly core services ex-shelter inflation, which includes prices for things like medical care, entertainment, tuition, and insurance, but not housing or energy—has been one of the Fed’s biggest areas of concern for years. As far back as November 2022, Powell said this metric “may be the most important category for understanding the future evolution” of inflation. There are a few reasons for that outlook. First, the services sector makes up more than 70% of the U.S. economy. And second, the core services ex-shelter inflation measure is often used to gauge something called cost-push inflation, which is driven by wage or wealth increases, and can signal rising prices have become entrenched in the economy.
Now, Rieder believes many wealthy, often older Americans who tend to spend more on services may be unwittingly preventing disinflation in this key sector of the economy.
“People over 55 are now big spenders—it’s actually pretty remarkable,” he said. “Particularly middle- to higher-income [seniors] now have a huge amount of savings. And that’s recirculating right into spending, including places that are sticky high, like entertainment, recreation, health care.”
To his point, older Americans tend to spend far more on entertainment, health care, and other service categories where the Fed is trying to fight inflation, the Bureau of Labor Statistics Consumer Expenditure survey shows.
In 2022, baby boomers spent an average of $3,476 on entertainment, while Gen Z spent about half that—just $1,693. Similarly, baby boomers spent an average of $7,116 on health care in 2022, compared with $4,156 for millennials and just $1,560 for Gen Z. “Those are the same areas you’re seeing service-level inflation, so it’s just hard to bring it down,” Rieder said.
Seniors are in a great position to keep spending in these key, service-inflation-boosting categories as well. Americans had a total of $147 trillion in assets as of the end of 2023, but roughly half of that wealth—$76 trillion—belonged to baby boomers, with the silent generation owning another $20 trillion, according to the Fed’s Survey of Consumer Finances. As Ed Yardeni, the veteran economist and market strategist who runs Yardeni Research, put it in a recent note: “They are the richest cohort of seniors ever.”
Older Americans are not only asset-rich, they also have far less debt than other generations, which means a steady stream of spending money for many of these new proverbial private lenders amid higher interest rates. In 2023, despite having far more assets, baby boomers had just $1.1 trillion in consumer debt, compared with $3.8 trillion for Gen X and millennials, according to Census data.
Similarly, baby boomers held $2.7 trillion in home mortgages in 2023, compared to $9.9 trillion for millennials and Gen X. Some 54% of baby boomer homeowners also own their homes outright, according to a Redfin survey, compared with roughly 40% of the total population. Yardeni noted that many older Americans had the opportunity to refinance their mortgages at record-low rates during 2020 and 2021 as well.
On top of all that, the majority of baby boomers have now completed college tuition payments for their kids; many just received Social Security increases; and others are finally earning a real return on their savings, leaving them plenty of money to spend. All of this is great for seniors and wealthy Americans, but it could be an issue for services inflation, according to Rieder.
And once again, it seems at least a few Fed officials agree with Rieder when it comes to the impact of higher rates on the wealthy. In the FOMC’s May 1 meeting, multiple participants “noted that financial conditions appeared favorable for wealthier households” in the first quarter.
Cash-rich businesses are profiting from higher rates
It’s not just wealthy, often older Americans who are changing the way interest rates impact the U.S. economy. There’s evidence that some of America’s largest companies were able to pay off debt, or lock in long-term low interest rate debt, before the Fed hiked interest rates. Now, these companies are earning a solid return by lending extra cash for the first time in over a decade as well, owing to the rise in interest rates. For Rieder, all of this means “it’s not clear that a higher rate doesn’t actually create more inflation.”
Rieder isn’t the only one who has made this argument either. In August 2023, Société Générale strategist Albert Edwards, the man known for lamenting the rise of greedflation during the COVID era, penned a note describing what he called the “maddest macro chart” in history. The chart, included below, showed that net interest payments by U.S. companies collapsed in 2022 and 2023, despite rising interest rates.
Higher interest rates are supposed to increase borrowing costs, according to economic orthodoxy, so what happened? It turns out, just as Rieder described, many companies were able to reduce their debt burdens or lock in low interest rate debt before the Fed hiked rates to fight inflation. (The central bank’s now infamous “transitory” call that delayed long-forecast interest rate hikes in 2021 gave time for many firms to prepare for a higher interest rate regime). Then, at the same time, many of these companies became lenders after rates rose. The net effect was large companies became “net beneficiaries of higher rates,” according to Edwards.
“Higher rates have added 5% to profits over the last year instead of deducting 10%+ from profits as usual,” he wrote in his August 2023 note. “Interest rates simply aren’t working as they once did.”
Edwards argued that the steady income rising interest rates provided to large companies helped the U.S. avoid a recession by boosting corporate profit margins and firming up the labor market last year. But now, BlackRock’s Rieder is warning the trend may also be contributing to the difficult battle against the last remnants of U.S. inflation. After all, creditors are doing quite well—and “the private sector has become a creditor now,” he said.
Rate cuts or not—Rieder still sees opportunity in fixed income
Given Rieder’s view on how higher interest rates are affecting inflation, it’s no wonder that he believes the Fed will cut rates this year. But even if the central bank doesn’t agree with his view regarding the impact of higher rates on the economy, Rieder still argued there is enough evidence for them to cut rates. There is “some moderate softening” in employment and consumer spending, and inflation, while still high, has been stable.
“As long as you get some stable, mid-twos core PCE [inflation numbers] … then I think the Fed can start to reduce that rate,” he said. “I just think the Fed would like to see a window that you’re not seeing accelerating inflation. And if you get a couple of months of that … you should have enough data to allow them to begin cutting.”
Rieder said he sees rate cuts coming by September, and the timing would certainly be advantageous for his first actively managed exchange-traded fund, launched in May 2023, the BlackRock Flexible Income ETF (BINC). BINC is a diversified bond and income ETF that seeks to offer clients exposure to higher-yield debt with lower volatility.
The ETF was seemingly launched with timing in mind. Bond prices tend to rise as yields fall, which means rate cuts would buoy Rieder’s holdings. Marketing materials from March 2023 even reference the “likely end of the Fed’s hiking cycle” which “creates expanded opportunities in fixed income.”
But Rieder said even if the Fed doesn’t cut rates right away, he believes bonds now offer an attractive opportunity for investors looking for stable income. “There’s yield everywhere. So you can stay in higher quality [bonds] than you have in the past,” he said.
With inflation remaining elevated, and forcing the Fed to hold rates higher, Rieder sees the current market as a golden opportunity for bond market investors to lock in higher yields, and maybe profit from some capital appreciation if rates do fall. “To me, it’s this incredible gift. Because inflation is staying where it is, we’re getting to buy credit assets cheaper than we should be,” he said.
Correction, May 24, 2024: An earlier version of this article misstated the date the BlackRock Flexible Income ETF was launched. The date is May 2023. One of Rieder’s quotes has been corrected from “turned” to “termed.”
