In 2021, inflation was between 5% and 7%, depending on which measure is used. Relative to 2016-2020, when inflation was between 1% and 2%, it is no wonder that the Federal Reserve Bank of St. Louis deemed 2021, the year of high inflation. In March 2022, the target federal funds rate, which is the interest rate the Federal Reserve has control over, was raised for the first time in two years, a clear response to increased inflation. As of October 2022, the economy continued to see relatively high inflation, an increase in the federal funds rate, a decline in the stock market, and relatively low levels of unemployment. This is why it has become increasingly difficult to understand current economic conditions. But in order to understand what is happening in the economy, and explain the motives for the decisions being made, it’s important to take a more practical approach.
Suppose my six-year-old daughter wants to start her own lemonade stand. To do this, she needs funds to buy supplies, advertising, and other general expenses associated with starting a business. There are multiple options for her to acquire these funds; one option would be for her to get a loan from a bank. When interest rates are low, it will be easier for her to make her interest payments, which provides her business with a greater chance of success. However, when interest rates are higher, she will have to earn a higher return from her lemonade stand to cover the higher interest payments. If the cost to raise money is high enough, she may decide not to start her business at all.
These are the types of decisions we all face every day as interest rates increase. But, to understand the actual impact of inflation on our everyday lives, we must first consider what inflation really is, and how it continues to shape our lives in ways we cannot yet fully understand.
Consider, for instance, the cost of the average movie ticket; in the 1980s it was about $2 dollars, and by 2022, that price has increased to an average of $11. It may not seem like much of a difference, but if you consider this price hike in comparison to the increased cost of living, you’ll start to get the fuller picture.
Inflation is the rate that your purchasing power declines because of price increases. For example, suppose you could purchase a sprocket for $100. If the price of a sprocket increases to $105 over the year, then the inflation rate is 5%. Effectively, your cash has lost 5% of its value through the loss of purchasing power.
There can be multiple causes of inflation. When demand exceeds the supply of a product, prices will rise. Another cause of inflation is when the cost of production increases, some of that cost will be passed on to consumers through higher prices. For example, if another company uses sprockets to produce their goods, then they will increase the price of their product when the price of sprockets increases. Finally, as prices rise, wages also rise to keep up with the cost of living.
So why should we care about inflation and how it impacts our lives? There are benefits to moderate inflation, as it generally leads to economic growth and is a sign of a healthy economy. One thing is certain, inflation is preferred to deflation. Deflation is the opposite of inflation, where price levels decrease over time. Deflation is detrimental to an economy because consumers are likely to spend less, waiting for prices to decline. The question is, how does one define “moderate inflation”? While there is a difference of opinion by economists, the Federal Reserve, which serves as the Central Bank of the United States, defines the target rate of moderate inflation as 2%.
The Federal Reserve has what is known as a dual mandate, which establishes two key economic goals. The Fed pursues policies that maximize employment and promote price stability. Price stability means keeping inflation low and stable. Although the dual mandate may sound relatively simple, maintaining low and stable inflation allows the economy to grow, which requires more workers to produce goods and services. However, this is not always the case. Sometimes, implementing one policy to achieve one goal will go against the other goal. This occurs because a key monetary policy tool of the Federal Reserve in setting a target range of inflation is the federal funds rate, or the interest rate that banks will charge when they lend excess cash they may have to another bank, typically on an overnight basis.
Over the course of 2022, the Federal Reserve has been increasing the federal funds rate in response to higher levels of inflation. While the federal funds rate is not an interest rate that you would use, it does create a starting point that impacts all other interest rates. When the Fed raises the federal funds rate, other rates such as mortgage rates also change, and these can directly affect us.
So how does the rising of interest rates combat inflation, really?
Suppose you have $10,000 and must decide whether to take a vacation to New England or save the money. When interest rates are low, you are less likely to save the money because you earn so little on that money. Instead, you would rather take the vacation to New England. The vacation contributes to higher demand (for hotels, restaurants, airfare etc.), which can cause prices to rise and increase inflation. However, if interest rates increase and you can earn more on your saving, you may be less inclined to take a vacation, to not forgo the higher rate of return on your savings. Taking the vacation is your opportunity cost to not saving. Opportunity cost is the next best alternative use of your money. As the Federal Reserve raises the federal funds rate and other interest rates rise, people become less likely to consume because the cost of that consumption increases.
As interest rates rise, consumers become less likely to spend and more likely to save. While this will, in theory, counteract inflation, it could also cause an economic slowdown. For example, if enough people no longer take that vacation to New England, then businesses that were relying on tourists will suffer and may reduce the number of employees they hire. Clearly, the Federal Reserve has a difficult job trying to moderate inflation without causing a recession.
The entire economy is affected when The Federal Reserve increases the federal funds rate. The clearest impact of this is how mortgage rates have increased as the Federal Reserve increased the federal funds rate (the mortgage rate is the interest rate on loans that individuals must pay to purchase a house). However, the interest rate itself is not the only thing impacted; the housing market itself is also impacted as mortgage rates increase. With higher mortgage rates, potential homeowners will have higher monthly payments. While some homebuyers will be able to afford the higher monthly payments, others will not, and home prices will fall as consumer demand decreases.
Another market that has been impacted by increasing rates is the stock market. This is not as straightforward as the mortgage market, but it’s still volatile. The VIX is the ticker symbol for the Chicago Board Options Exchange’s CBOE Volatility Index, which measures expected volatility of the S&P 500. The VIX has been higher in 2022 than in previous years, which is due to the uncertainty in the economy. While increasing interest rates can help bring inflation down to a moderate level, there is a risk of an economic downturn if rates go too high. The large daily fluctuation of prices in the stock market is a result of this uncertainty.
So with interest rates increasing combined with the unpredictable volatility of the stock market, it’s difficult to know whether we should save more money, or spend it on goods. Should we reduce the amount we borrow or continue to consume? Do we invest in riskier assets to try to earn higher return?
While there are no easy answers to these questions, understanding what is happening with inflation, the economy, and interest rates are important when making decisions. Luckily my daughter, has someone who would be happy to provide her with a little bit of seed money to start her business. In fact, he would even help her mix the lemonade.