On the Fed, Interest Rates, and Inflation (Part 2)

Has rising inflation got you down? In our last newsletter we explored how rising interest rates can impact a healthy economy. Today, let’s explore inflation in more detail.

How Do We Measure Inflation?
Inflation is the rate at which money loses its purchasing power over time. As you might guess, there are many ways to measure it; and there are various economic sectors, such as energy, food, housing, and healthcare, which can complicate the equation by exhibiting wildly different inflation rates at different times.

There also is today’s inflation rate, versus the rate at which inflation is expected to change over time. For example:

  • Measured by the U.S. Consumer Price Index, inflation stood at a March 2022 annual rate of 8.5%, fueled significantly by increased energy prices.
  • Measured by the Intercontinental Exchange (ICE) U.S. Dollar Inflation Expectations, 1 Year Expected Inflation was at 5.27% on April 11, 2022.

While that’s a wide range of numbers for seemingly the same figure, they all share one point in common: By nearly any measure, inflation is higher than it’s been in quite a while, and $1 doesn’t buy what it used to.

But what should we make of that information? As usual, it helps to consider current events in historical context to discover informative insights.

Inflationary Times: Past and Present
Unless you’re at least in your 60s, you’ve probably never experienced steep inflation in your lifetime—at least not in the U.S., where the last time inflation was as high (and higher) was in the early 1980s. After years of high inflation that began in the late 1960s and peaked at a feverish 14.8% in 1980, Americans were literally marching in the streets over the price of groceries, waving protest signs such as, “50¢ worth of chuck shouldn’t cost us a buck.”

During his 1979–1987 tenure, Federal Reserve chair Paul Volcker is credited with routing the runaway inflation by ratcheting up the Federal funds target rate to a peak of 20% by 1980 (compare that to the recent increase to 0.25%). Volker’s Fed wanted to reduce the feverish spending and lending that had become the status quo. These strategies apparently effected a cure to high inflation, or at least contributed to one. By 1983, inflation had dropped considerably closer to its target rate of 2%, around which it has mostly hovered ever since. Until now.

The Inflationary Past Is Not Always Prelude
Why not just ratchet up the Fed’s target rates as Volcker did? Unfortunately, it’s not that simple. First, there are several broad categories—such as supply and demand, rising labor and production costs, and a nation’s monetary policies—each of which can contribute to inflation individually or in combination. This means each inflationary period is born of unique circumstances. Just because sharply higher rates worked in the past, doesn’t mean the economy will respond the same way in the present.

Second, even if an inflation-busting action does work, there can be secondary and tertiary effects that could be worse than high inflation alone.

Volcker’s actions are a case in point. The higher target rates not only tamed inflation, they weakened the economy significantly, leading to an early 1980s “double dip” recession and high unemployment. Overall unemployment hovered above 7% for several years. Even if the outcome was worth the pain involved, it’s not a course one embraces with enthusiasm.

What’s Next for Inflation
Are we doomed to reach double-digit levels of inflation this time, face another painful recession, or both? As always, time will tell. However, in the face of today’s challenges, we choose cautious optimism over fear. This is not because we’re naïve or blind to the facts, but because we are guided by the dynamic nature of our economy.

In thinking about current inflation, we can accept that, yes, inflation has become uncomfortably high. Labor costs, supply constraints, low interest rates, and high spending have all likely contributed to inflated costs, and these same factors can feed on one another – which can then cause inflation to rise even higher.

But then what will happen? In reality, next-step responses are already starting to take place. The Fed has raised interest rates once, and plans to continue raising them throughout 2022. They will also be reducing their nearly $9 trillion balance sheet, further reducing the money supply. Likewise, businesses are revisiting their growth plans, and consumers are thinking twice about their purchases, especially in markets where inflation is having its greatest impact.

It probably won’t happen overnight, but these next steps should chip away at inflation. True, this could lead to a recession … or not. We hope not. Either way, then what will happen? Once again, governments, businesses, and individuals will likely adjust their behaviors and expectations in response. And so on. Even if the odds are heavily stacked in favor of our taming inflation over time, this is not to suggest it will be easy. And even if we “win” in the end, it’s unlikely it will be obvious until we are able to look back at the events with the benefit of hindsight.

As always, please reach out to us with any questions or concerns.