Posted on February 24, 2022 in

Understanding Inflation

Inflation is a hot topic. Most consumers are feeling the pain at the pump, and the grocery store. Investors and savers alike are wondering where inflation came from, why policymakers are reluctant to take action, and how to protect and grow wealth in an environment where inflation is at 40-year highs.

Commentators and politicians are quick to blame post-pandemic inflation on the Federal Reserve. As the pandemic’s impact on the economy became clear, the Fed cut interest rates and started buying bonds to provide liquidity to the financial system. These tools are the same ones the Fed used to support the economy after the Great Financial Crisis.

The Fed’s monetary policies after 2008 did not create a wave of inflation like the one we are currently experiencing. In the aftermath of the Great Financial Crisis, inflation was persistently below the Fed’s target. Although the Fed was “creating money” through its policy tools, most of that money didn’t find it’s way into the broader economy. The lesson here is that increasing the money supply alone isn’t enough to trigger inflation. Inflation also requires dollars in the system to be “turned over” more rapidly. In other words, the velocity of money matters. Velocity is lower now than it has been in four decades.

If Fed Policy Isn’t Driving Today’s Inflation, Why Is It Happening?

Pandemic-related programs created by the Fed were designed to provide liquidity to financial institutions. The Fed’s objective was to protect the banking system and capital markets, not to put money in the pockets of businesses and consumers. However, the US Government’s policy response to the pandemic was designed to do exactly that.

The Federal Government has spent $3.59 trillion in response to COVID-19[1]. Over $850 billion dollars of direct payments were made directly to taxpayers via Economic Impact Payments. A further $811 billion was spent on the Paycheck Protection Program. Unlike funds from the Fed’s liquidity programs, these dollars have found their way into the broader economy.

These programs protected the economy from a severe downturn that would have otherwise likely happened as a result of pandemic-related restrictions and lockdowns. This has created a situation where consumers are flush with cash, and businesses are unable to keep up with demand. Global supply chains are healing, but demand is still well above supply, resulting in a wave of rising prices for everything from groceries to used cars.

The Federal Reserve is now in a tough position. In textbook economics, the cure for inflation is to raise interest rates. However, by raising rates too aggressively, the Fed could set the economy on a path toward recession. The Federal Reserve has tools that it can use to slow down consumer demand, but there is little the Fed can do increase the supply of goods.

Most businesses will be reluctant to invest in increasing production if they see a recession on the horizon. An aggressive response to “tame inflation” like the Fed used in the late 1970’s and early 1980’s could create further supply chain problems by causing businesses to reduce production. This explains why the Fed has been reluctant to take action despite significant increases in the consumer price index.

The prices of some things are likely to remain high. However, history shows that for many commodities prices are highly cyclical. Gasoline is much more expensive than it was a year ago, but gas prices are actually lower now than most of the 2011-2014 period. Prices of grocery store items like beef and coffee are high, but these have a history of very wide swings. In the long run, supply and demand will find a balance.

What Does This Mean for Savers and Investors?

For savers, the first thing to consider is your emergency fund. It probably needs to be bigger now than it was a year ago. Being very aware of where you are spending money is critical. We can’t control the price of things in the grocery store, but we can pay attention to how we spend our money. It’s also important to continue to save money, to save in the right places, and to invest in ways that are proven to beat inflation over time.

[1] Data from www.USASpending.gov, the official source for spending data provided by the US Government.

Matthew A Treskovich | CFA, CPA/PFS, CITP, CMA, CFP®, AEP®, MBA, CLU, ChFC
Chief Investment Officer