Inflation is hardly a topic that most of us find riveting. But, it is an issue that is deeply affecting many people right now and for the foreseeable future. While I am not an economist, working in the field of finance provides substantial exposure to news on this topic.
Inflation has a profound affect on our personal finances both currently and as relates to our future plans.
Inflation is frightening. And knowledge is one of the best ways to combat fear. So I am providing an overview on what is currently happening in the U.S. economy. The explanation won’t make prices go down but hopefully it will give you a better sense of why we seem to be paying more for nearly everything.
Supply and Demand
Let’s start with a basic economic principle that may be familiar to you, supply and demand. Supply is the amount of a product or service available. Demand is how much of that product or service people want. If the supply of an item is higher than then demand then the producer/supplier of the good or service will need to reduce the prices in order to entice people to buy that good or service. This is the idea behind sales. If no one was willing to buy a jacket for $100, the seller may reduce the price to $50 in order to find a buyer.
If, however, demand is greater than supply, prices go up. Lots of people want to buy a good or service and there is not a high enough supply to meet the demand. This results in the seller increasing the prices. Some folks may not be willing or able to pay the higher amount, but enough others are that the seller can get more money overall for the same quantity of products/services.
Explaining Inflation
Inflation is “the rate at which the prices of products and services change over a given period (usually a year.)” (What is Inflation?) In other words, inflation is the increase in cost that happens year over year.
We expect inflation to occur. This is why we (hopefully) receive cost of living increases at work, pensions, etc. But, currently in the United States, we are experiencing extremely high levels of inflation. From 1960 to 2021 the average inflation rate was 3.8% per year. In 2022, however, the inflation rate from January through September was 8.2%. When costs are going up 2-3% over a year it may not be very noticeable. But an increase averaging nearly 1% per month has caused considerable financial stress for many.
Why is Inflation so High?
The pandemic played a large role in our current rise in inflation. People being home-bound, combined with federal stimulus checks, resulted in an increased demand for goods in 2020-2021. A decreased demand for many services (haircuts, vacations, dining) occurred during this same period. These changes resulted in global supply chain problems. People changed their spending habits more quickly than the production and distribution of goods was unable adjust to the change.
The war in the Ukraine has also played a role in price increases. Russia provides about 10% of the global oil supply. The US and the EU have placed restrictions and bans on US gas and oil. The reduction of supply has affected the price. When gas gets more expensive, so does everything else. Transport and distribution of goods costs companies more and they raise their prices accordingly.
While all of these economic factors are at play, we should also consider potential political influences. The concept of supply and demand is dependent upon the idea of a free economy without outside interference. In reality, however, we do not have a completely free economy. We are affected by individual and corporate taxation, corporate subsidies, and monopolies. Professor Robert Reich explains on Inequality Media how we should look at America’s monopolies as a cause of the current inflation.
The Role of the Fed
The Federal Reserve Board (aka “the Fed”) is an agency of the US Government. The Fed has been “assigned the Fed to conduct the nation’s monetary policy to support the goals of maximum employment, stable prices, and moderate long-term interest rates.” (The board of Governors). Simply put, the Fed strives to keep unemployment low and inflation low. The Fed has a target inflation rate of 2% while striving for maximum employment. Unfortunately, these two goals do not always go hand-in-hand.
The United States had low unemployment numbers and low inflation for many years. This changed, however, with the onset of the pandemic. When the Federal Reserve Board becomes concerned about inflation or employment numbers it takes action.
You have likely heard about the Fed “raising rates.” But what does that mean?
The Fed loans money to commercial banks who, in turn, loan to consumers. The Fed loans that money at the federal funds rate, a rate determined by the Federal Open Market Committee (FOMC). When the FOMC raises the federal funds rate, commercial banks have to pay more to borrow money. In turn, the banks charge a greater interest rate when they are loaning money. When businesses and individuals have to pay more to borrow money, they spend less. When people spend less, the economy slows.
Simply put: the Fed charges banks more > banks charge business more > businesses & individuals spend less > economy slows > inflation slows.
And, conversely, when the Fed lowers rates inflation increases. This Forbes article provides detailed information on the history of and reasoning behind prior Fed rate changes.
The Economy
The phrase “the economy” is thrown around a lot in the news. But, what is the economy really?
According to Investopedia, “An economy is a complex system of interrelated production, consumption, and exchange activities that ultimately determines how resources are allocated among all the participants.” So, the economy is just how much is being produced and consumed. When we refer to a strong economy that means that a lot of products and services are being made and used. A week economy refers to a period with less production and consumption.
For the minimalists and environmentalists reading, this definition may be cause to question whether a strong economy is always a good thing. Is there a point at which production and consumption are high enough to cause more harm then good?
Conversely, from a humanitarian standpoint, when the economy weakens it is generally the most vulnerable who suffer. Along with wealthier individuals cutting back on luxury goods, reduced economic activity frequently means poorer people have less access to necessities such as food and shelter.
How Does this All Fit Together?
The idea that raising interest rates will bring down prices feels counter-intuitive. If interest rates go up then won’t companies have to charge even more for their products or services?
This is where supply and demand comes in. As discussed above, inflation occurs when demand is greater than supply. Lots of people are competing for fewer items so the price goes up. Increasing interest rates cause a decrease in demand. Money becomes more expensive so people buy less. When people buy less then prices go down to attract more buyers.
Let’s look at the example of the housing market. Lets say that someone wants to buy a home for $500,000. They put 20%, or $100,000 down and get a 30 year fixed mortgage for the remaining $400,000. If the interest rate on their mortgage is 3% then the monthly mortgage payment (excluding escrow) will be $1770. If, however, the mortgage has an interest rate of 6%, then the monthly payments would be $2,482. That is a difference of $712/month in mortgage payments.
For most home buyers, an increase in the interest rate means that they will need to purchase a less expensive home so that they can afford the mortgage payments. Using the above example, the person with $100,000 for a down payment and $1770/month for a mortgage would find that if interest rates are at 6% they could only afford to pay $380,000 for a new home.
Let’s consider what this means from the side of the person selling the home. They will find there are less people willing to pay $500,000 for their home. The demand has gone down. Likely they will need to reduce the home price to find a buyer.
You can see in this example how interest rate increases will cause the price of a product to drop. This is how increased interest rates can decrease inflation.
Moving Toward Recession
The high inflation in 2021 resulted in the Federal Reserve Board has decided that inflation has gotten so high it is necessary to combat it with an increase to interest rates. In 2022 the Fed increased the Federal funds rate by nearly five hundred percentage points or 5%.
*Side note: When you see “percentage points” that simply means 1/100 of a percent. One hundred percentage points (pp) is 1%. You may also hear this referred to as a basis point which is abbreviated as BP and pronounced “bip.” Just more financial language to keep people feeling confused.
The problem, as we all witnessed, is that rapidly increasing interest rates generally leads to recession.
When money becomes more expensive, then people buy less. When people buy less, then companies produce less. Companies producing less means they need fewer workers. As jobs are cut, people have less money to spend.
As mentioned above, the Fed’s imperative is to keep inflation low and employment high. The Fed is currently raising interest rates to slow inflation. As they do so, they slow the economy which increases unemployment. When unemployment levels reach a number that the Fed views as problematic, then they take the reverse action. They cut interest rates to stimulate the economy and increase employment. And so the cycle continues.
Dealing with Inflation
The recent and rapid increase in inflation is a systemic economic problem that none of us have any control over. Inflation is hard on nearly everybody. Middle and upper middle class individuals may find it prudent to cut back on luxury purchases, travel, and entertainment. Those a bit less secure in their finances may really start pinching pennies and watching their grocery and gas purchases carefully. Sadly, the most vulnerable are the most affected.
The inflation rate will eventually drop. But that does not mean lower prices, it simply means that prices will be rising at a slower rate.
Deflation is the term used for the decreasing purchasing power of the dollar. In other words, deflation is when prices go down. The Fed guards against this carefully and we have not seen major deflation since the Great Depression. As much as most of us would like to see prices drop to the levels of six months ago, deflation is generally considered negative and more harmful than inflation.
On a personal level, we can use this as an opportunity to review our spending and our priorities. I don’t wish to sugar coat the situation, I know it is not easy.
For those who are able, plan ahead, delay/limit discretionary purchases, and to save to an emergency fund. Expect to pay higher prices and consider what purchases and investments are actually worth the money. Knowing that the higher prices are here to stay, we should all take this into account when we consider our purchases, negotiate our salaries, and manage our savings.
There is no magic bullet for dealing with inflation. My hope is that this explanation has provided you with a more complete picture of our current economy. Even when we have no personal control, having clarity regarding the situation can improve our confidence and feeling of well being.