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Let's Talk Inflation: What is it & How is it Controlled?

Let's Talk Inflation: What is it & How is it Controlled?

April 07, 2021

Inflation impacts everyone, whether or not they realize it. It may not be something that's always at the forefront of your mind, but you may be reminded of inflation when you notice the cost of something such as the price of milk has gone up. When the overall cost of living increases but wages don't increase to keep pace, most people will become more aware of inflation's impacts.

Inflation is a factor considered in financial planning goals because of the time value of money. $1,000 was worth more in 1950 than it is now in 2021.

This month I want to talk about inflation, what it is and how the federal government monitors and controls inflation. I also want to provide an overview of inflation rates, past, present, and future, and how the Fiscal Package (1.9 Trillion Spending Bill) may affect inflation.

What is Inflation?

The U.S. inflation rate is the percentage of change in product and service prices from one year to the next and is a measurement tool that speaks to a country's economic health. This tool is frequently used by our central bank, government, and economists. The inflation helps these entities gauge if our economy is healthy, meaning businesses are producing and consumers are spending. An economy with a healthy inflation rate likely will see a strong balance between supply and demand.

Inflation occurs when the price level of goods and services experience a continuous increase in cost. When the cost of goods and services goes up, your money doesn’t go as far, which means that the currency's value (i.e., the U.S. dollar) itself is worth less.

Deflation is when the inflation rate falls below zero. When inflation falls below zero, prices go down, but unemployment goes up. Deflation also lowers the value of a currency over time, can cause a recession, and sometimes be even more dangerous than inflation.

Supply and Demand:
When the demand for a product is higher than the product's supply, the cost will most likely be higher. Conversely, if there is more product supply than demand for the product, you will most likely see a decrease in the price. In our current economy, COVID-19 has been impacted by slowed production and impeded transit. This delay in productivity and delivery of products will ultimately see a price increase due to the imbalance that has been created between supply and demand.

Demand-Pull Inflation
The first time I remember seeing supply and demand in action was on the news footage in 1996 when the Tickle Me Elmo was released for the first time. Chaos ensued in stores across the nation as some parents even resorted to fistfights to get their hands on the giggly red toy. The Elmo pandemonium is an example of 'demand-pull inflation.' You can also see demand-pull inflation with the release of a new iPhone or Xbox, for example.

Cost-Push Inflation
In the second quarter of 2020, at the beginning of the COVID-19 pandemic, we saw the cost of hand sanitizer, personal protective equipment (PPE), and toilet paper skyrocketed because the demand became so much larger than the available supply. The increased need for these supplies, the increase in the cost for the materials to make these items, and the cost of labor needed to produce caused 'cost-push inflation,' making these items much more expensive. Once the supply of these materials caught up, and in some cases, even surpassed the need, the prices began to drop, and you can now find clearance aisles stocked full of hand sanitizer.

The Role of the Federal Reserve System
The Federal Reserve System (referred to as 'The Fed') was established when Congress passed the 1913 Federal Reserve Act. The creation of the Fed came on the heels of concerns about the safety of money in banks.

The Fed was created to foster economic stability, social welfare and to have one central bank that oversees monetary policy. To fulfill this purpose, the Fed created the 'dual mandate' that maximizes employment and keeps inflation and prices stable. The Fed wants prices to remain stable, not rising or falling too quickly. The Fed sees 2% as the optimum rate of inflation per year. This percentage of inflation is decided by the price index of personal consumption expenditures.

The Fed controls inflation by changing interest rates. When inflation is at risk of getting too high, the Fed will typically raise interest rates, which causes the economy to slow down, which, as a result, brings inflation down. When inflation becomes too low, the Fed will typically lower interest rates, stimulate the economy, and raise inflation.

Inflation: Past, Present, and Future

Past: The Fed funds rate reached its highest point in 1980 at 20.0%; this staggering rise was to battle double-digit inflation. Inflation hit the roof in the 1970s due to President Richard Nixon's decision to disengage the dollar from the gold standard and the Fed's use of stop-go inflation rates.

All of the sudden changes resulting from the stop-go monetary policy were not kept in effect long enough to end inflation or spur growth. Inflation rates worsened as businesses had to keep their prices high to stay ahead of the unpredictable and significant Fed interest rate increases. Leaders of the Fed then realized that it was critical to manage inflation expectations to control inflation itself.

In 1979, the Fed ended their stop-go policy, which raised rates but kept them stable to finally end the wildly unpredictable inflation. This change spurred the recession of 1980 but ended double-digit inflation, and it hasn't been an issue since.

The all-time low Fed rate is effectively zero. The Fed lowered the rate to a range of 0.0% to 0.25% during the financial crisis of 2008. 2020's inflation rate was 1.2%.

Present: The Fed enacted the all-time-low Fed rate of effectively zero again in March 2020. In September of 2020, the Fed stated that it would keep its rates in this range until 2023. In March 2021, at the Federal Open Market Committee (FOMC) meeting, the Fed echoed their previous statement of keeping the target fed funds rate at a range of 0.0% to 0.25% and will continue to do so until inflation surpasses its target of 2%. There has been a lot of concern recently over inflation, the Fed is currently taking proactive measures to keep inflation low and prioritize employment. Per the FOMC, 2021's forecasted inflation rate is 1.8%.

The COVID-19 Pandemic shook our economy and caused a widespread stifling of supply and demand. U.S. stocks were reaching record highs while Congress progressed with the passage of the $1.9 trillion fiscal package. Between the fiscal package and the increase in vaccinations in the U.S., our business cycle may see what feels like a complete restart.

A substantial fall in demand is a factor that may lead to a recession, , but the pandemic caused a fall in supply and demand. In a typical recession, demand slowly meets back up with supply. However, since the pandemic caused a fall in both supply and demand, both sides have to play catch up.

Unfortunately, millions of small businesses have permanently closed over the last year, and large companies also had to cut costs, including staffing. If companies fail to keep up with the surges in demand, it could cause additional price increases in the short-term.

A rise in our current inflation rate is a possibility but it is expected to stay low for a while, considering the Fed rates and stricter banking regulations that limit the effectiveness of fiscal policies. With these considerations taken into factor, inflation is more likely to continue to be contained.

The $1.9 trillion package's fiscal thrust will be great for a boost in the short-term to the U.S. economy; what remains to be seen is if it will be enough to create meaningful growth to the gross domestic product. The FOMC's forecasted inflation rate for the next few years is between 1.8% - 2%

Key Take-Aways

- Inflation fluctuates and varies year-to-year
- The Fed monitors and controls inflation with the federal funds rate.
- The economic future of the U.S. is uncertain in terms of employment and production.
- Inflation and interest rates are currently expected to remain low for some time.

Do you have questions on your mind about how our current economy may be affecting your financial wellness or how you can diversify your portfolio to mitigate inflation risk and other factors? Schedule a meeting; I am here to help!




1913 Federal Reserve Act Definition (