What is inflation? Inflation occurs when the price of goods and services rise but household incomes do not. This, in effect, reduces the amount a dollar can purchase and therefore erodes the household budget.
What causes inflation? With the Keynesian theory of supply and demand, if supply is great and demand is low, the price of goods and services will fall. The reverse is true if demand is great and supply is low, the prices go up. This is the simplest cause of inflation as we are seeing it today.
The causes of recessions are far too varied to list, but the tools to fight recessions are few. In recessions, the price of goods and services are falling so people tend to wait to make purchases with the idea that they will cost less in the future.
The tools that the Federal Reserve uses to fight recessions are inverse to the tools used to fight inflation. If inflation is rising, the Federal Reserve wants to decrease the supply of money which reduces the amount of money available to purchase goods and services. To do this, they raise interest rates on the federal level thereby raising rates beyond where banks are willing to lend money. This makes it so fewer loans are applied for and agreed to. The Federal Reserve can also sell notes and bonds so that people buy debt from the government instead of buying consumer goods.
During the Great Recession and afterwards, to increase inflation, the Federal Reserve reduced interest rates pushing more money into the economy. They also bought federal notes and bonds and bought investment grade bonds in the open market. Because there were a limited number of bonds available, many investors were locked out of the bond market and were forced either to the stock market, savings, or spending. The bond and stock markets were driven to new highs and increased wealth. Although, much to the dislike of the government, it did not drive-up inflation.
Now we get to 2020 and 2021. We entered 2020 with a Federal Fund interest rate at about 0% and inflation running around 1%. These numbers do not indicate a healthy economy but instead one that could easily fall to a recession. The pandemic and Congress’s intervention has almost solved this problem. With the pandemic came job loss, company closures, and a never-ending stream of federal money being infused into the economy. As the vaccines began to be offered, people realized that perhaps life could return to a more normal state and therefore spending began. With the inflows of funds through all of 2020 and the beginning of 2021, cash was readily available, but products were not. In the month of May 2021, inflation was 5% higher than just the year before. Yes, the inflation that the government had been trying to get since 2008, had finally begun. Now of course the fear is, can it be controlled?
So, as Congress and the money printing press bring inflation up, the Feds are now walking a tight rope of when to begin raising interest rates and selling off the government and corporate bonds that they bought pre-pandemic. This is the debate today and one of the reasons for market concern this year.
The economy needs to have the Fed Fund rate higher to fight future recessions. People living on a fixed income need to earn higher interest on their investments, so they can keep pace with inflation. The housing market does not want interest rates to rise because they are counting on a larger, not a smaller, population to be able to qualify for large mortgages at historic low rates. Corporations do not want interest rates to go up, because that raises the cost of debt used to buy machinery and equipment to grow their business.
As you can see this is a very difficult situation. One that the government will have to carefully plan for and strategize through as we all adjust to higher interest rates and higher inflation.