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How Inflation and The Federal Reserve are Connected

Categories: Insights |
Estimated Reading Time:
5 minutes

We have been seeing headlines about inflation for quite some time now. Often, those headlines are paired with notes on what ‘the Fed’ is saying or doing. Fractions of percentages, discussion on economic risk, and more are part of the conversation.

The Federal Reserve, usually referred to as the Fed, is tasked with maintaining inflation at a reasonable level for the U.S. economy. But how does it go about doing so?

Inflation Triggers

To understand the ways in which Federal Reserve policy is designed to combat inflation, it is helpful to first step back to consider what causes inflation in the first place.

On its most basic level, the price of something is determined by the intersection of supply and demand. All else equal, the more people who want to buy a certain good, the more expensive you would expect it to become, and vice versa. Similarly, when the quantity available for sale increases, you would expect its price to decrease as sellers offer discounts in order to turn over more inventory.

Under normal circumstances, prevailing market prices are expected to settle into an equilibrium level reflecting the balance between existing supply and demand. While supply and demand will shift over time, these changes are generally slow-moving, resulting in the modest levels of aggregate inflation that we have become accustomed to over the past forty years. Following the onset of the COVID-19 pandemic, however, the economy experienced a series of massive shocks to both supply and demand.

On the supply side, the initial lockdowns in early 2020 brought global manufacturing and logistics to a standstill. Like a car slamming on its brakes on the highway creating a traffic jam that remains long after the initial obstruction has cleared, the backlogs in the global supply chain have still not fully resolved more than two years after the majority of lockdowns were lifted. Fewer goods being produced and delivered to stores means supply was down and inflationary pressures were up.

At the same time prices were being pushed up by supply constraints, the demand side of the economy was adding its fuel to the fire. Even with the widespread spike in joblessness, massive fiscal stimulus ensured that consumers maintained—or often increased—their incomes whether or not they lost their job during the pandemic. Add to this a surge in average wage growth throughout 2021 and the wealth effect created by booming asset prices (as the dollar value of invested assets increased, many of us tend to spend more) and the net result of this one-two punch of supply-push and demand-pull pressures was the highest levels of inflation in a generation.

Federal Reserve Policy

With this backdrop in mind, we return to the Federal Reserve. Mandated with maintaining stable prices, the Federal Reserve has shifted its stance over the last year from accommodative—actively seeking to support prices in the wake of the initial COVID disruptions—to restrictive, as inflation has proven to be less ‘transitory’ than originally anticipated. While the unconventional monetary policies unveiled in the years following the Great Financial Crisis of 2008/9 have demonstrated the enormous power and resources the Fed has its disposal, it is not equipped in the same way when it comes to drilling for oil or unloading container ships. Although prices are ultimately a function of both supply and demand, the realities of the Federal Reserve’s toolkit mean it is only able to directly impact one side of the price equation – the demand side related to interest rates and access to funds.

As the expression goes, “to a man with only a hammer, everything looks like a nail,” and in the eyes of The Federal Reserve, interest rates are the nails that hold the economy together. During times of weakness, it pushes down interest rates, lowering the cost of money in the economy to spur demand growth. Cheap capital makes financing more available. Banks are willing to extend loans to borrowers who they may have deemed uncreditworthy at a higher cost of financing, companies are willing to make investments that may have been uneconomical at higher rates, and consumers are more willing and able to take on loans to buy a home or purchase goods.

Conversely, when demand outstrips supply and inflation rises above healthy levels, The Federal Reserve will take steps to increase interest rates in an effort to cool the economy. While this seems like a relatively simple formula in theory, in practice, the specific tools The Federal Reserve utilizes to implement its interest rate policy can have a wide range of effects on different parts of the economy.

Fed Policy

When people talk about Fed policy, they are referring to changes in the Federal Funds rate — the rate at which banks and other depository institutions are able borrow directly from the Federal Reserve on an overnight basis. Although very few players within the economy can actually transact at this rate, other consumer-based financial institutions provide interest rates based on Prime, which is itself based off of the Federal Funds rate. Because of this the rate has historically been the one that has received the most attention.

However, this indirect relationship makes the Fed Funds Rate a somewhat crude tool for effecting policy. On the one hand, it is overly broad, causing financial conditions to tighten everywhere and threatening to derail growth altogether. On the other hand, it can have only tenuous impacts on some of the rates that tend to matter more for taming excess demand. Mortgage rates, for example, are impacted by changes in longer-term government bond yields, not the Fed Funds Rate.

In a vacuum, changes to policy at the front end of the curve should be expected to flow through to the longer end. In practice, however, prices for everything beyond the overnight rate are set by the market, and the further you get from the overnight rate, the less the Fed is able to influence things via traditional policy tools.

Because of this, they have implemented a series of unconventional policy tools to more directly target different parts of the economy. Some of these tactics include allowing the Fed’s balance sheet to decrease through Quantitative Tightening, adjusting other interest rates directly related to Federal Reserve funds, and modifying some requirements for financial institutions to follow.

While we are still walking through a period of high inflation, we can see that the causes were many. The Federal Reserve has used both it’s abilities to adjust the Federal Funds interest rate, as well as other, more direct methods to help curb inflation to a more sustainable level.

This tightening cycle by the Fed is unlikely to closely resemble those that have come before, as there continue to be ‘different than the norm’ complicating factors such as job market growth and low unemployment at play in the

Just what that means for the economy—and for investment returns going forward—remains to be seen.

If you have concerns, questions, or feel overwhelmed about how inflation may be affecting your retirement plans or investments, it can be helpful to speak to a financial advisor who is a CERTIFIED FINANCIAL PLANNER Professional, especially at a firm like Domani Wealth which also includes many layers of credentials such as Chartered Financial Analysts throughout our team. Please feel free to reach out at any time, we are happy to start a conversation, by calling 855-555-5455 or emailing info@domaniwealth.com.

Important Disclosure

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Domani. A copy of Domani’s current written disclosure brochure discussing our advisory services and fees continues to remain available upon request.

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