Wealth Management Mailbag: Fall 2022
Why is inflation so hard to tamp down?
Answered by Ross Mayfield, Investment Strategy Analyst at Baird
At its core, inflation can be defined as a misalignment of supply and demand – either too much demand or too little supply. One of the reasons today’s inflation is so tough to bring down is because this time it’s both (economists at the NY Fed assign a 60-40 split). Trillions of dollars in fiscal stimulus combined with a reopening economy boosted demand for goods and services to historic levels. Simultaneously, the world experienced shortages of nearly everything fathomable – the pandemic caused factories to shutter, ports to clog and semitrucks to idle. War in Ukraine has hindered the flow of oil and gas. There is a troubling worker shortage in the U.S. that could keep the labor market tight and wage inflation elevated. All in all, a strong post-Covid economy and flush consumers met a world short in supply of everything from used cars to fry cooks. To accommodate this imbalance, prices rose.
Another issue is that the Federal Reserve really only has one tool to fight inflation – raising interest rates to curb demand. Mike has more below, but simply put, the Federal Reserve isn’t in the “supply” business: They cannot pump more oil or plant more crops. They operate on the “demand” side: Raise interest rates, make borrowing more expensive and reduce demand. Unfortunately, this action can take a lot of time to infiltrate the economy and change behavior, especially when the consumer is in pretty good financial shape. Monetary policy acts with “a long and variable” lag time, which is to say that the medicine is only now just starting to hit the bloodstream and may take some time to work.
Finally, there is an expectations component to inflation: The degree to which both consumers and business operators expect future prices to rise will influence their behavior today. If consumers expect inflation to remain elevated, they may make larger purchases in the near-term (or hoard items in extreme cases). Meanwhile businesses might raise prices beyond how much their costs are going up simply because they believe consumers can and will pay them. As inflation lingers, expectations for higher inflation become more entrenched and actually reinforce the inflationary cycle.
In the end, it’s a complex and difficult problem, and we are seeing just how hard it is to root high inflation out of the system.
What does it mean when the Fed raises rates?
Answered by Mike Antonelli, PWM Market Strategist at Baird
Ross alluded above that raising rates is the Federal Reserve’s only tool to fight inflation. You might be wondering, “What rates are they raising and how does that impact me?” To answer, let’s first discuss the purpose behind the Fed.
The U.S. Federal Reserve has two goals: To help ensure maximum employment and foster price stability. The first of those goals is well in hand: As of November 2022, the unemployment rate in the United States was 3.8%, one of the lowest levels in decades.
It’s the second goal that they are working on – price stability.
Inflation, as we all feel every day, is higher than it’s been in years – and for a lot of reasons, ranging from protracted supply chain challenges to China’s zero-COVID policy. The Federal Reserve has only one weapon to lower it: They can raise interest rates. And when they “raise rates,” what they are trying to do is make money more expensive. That’s really it.
- When money becomes more expensive, people (and companies) do and spend less.
- When they do and spend less, the economy slows.
- When the economy slows, inflation falls.
So which interest rates are they raising? The Fed raises and lowers something called the Fed Funds rate – the rate at which banks lend to each other overnight. Many of the interest rates in our lives, from credit cards to mortgages to what companies borrow for, rise and fall with what the Fed does. Let's use housing as an example:
In 2021, home prices were out of control – most markets across the country saw home prices increase by close to 20% in one year. That is incredibly unhealthy for all sorts of reasons.
When the Fed hikes interest rates, the 30-year mortgage rate rises. When mortgages get more expensive, fewer people can afford homes. When fewer people can afford a home, the “demand” side of the supply-and-demand equation goes down, and home prices stabilize (and potentially fall).
But as we’ve seen, the stock market hates all of this. It hates when an entity as powerful as the Federal Reserve openly tries to slow the economy. When the Fed starts pushing on the brakes, stocks struggle.
You might be wondering, “How does raising rates help put more bacon in supermarkets, cars on lots and gas in gas pumps? If our issues are supply-related, how does raising rates help?” And you’d be right to ponder that –because it doesn’t, not directly. But that’s an issue for policymakers and not the Federal Reserve. Rightly or wrongly – and there are arguments on both sides – the Fed has prioritized bringing down inflation over the health of the stock market, at least in the short term. They have one tool, and it’s blunt – to make money more expensive so people do less things.
That’s all they have, and they’ll use it until inflation is beaten.
The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.