Yes, we are still talking about inflation and interest rates!
Oh, inflation – how we loathe you. How we long for your normalization. But… do we really understand why we loathe you, or what normalization means? Why is it still so stinking high? Why should we care? What are the real ways that it affects me?
There is so much to unpack here. So. Much. I am also constantly hearing or seeing a lot of incorrect information out there. There are a lot of opinions being tossed around as facts. We won’t be able to address all of that here today, but I’ll do my best to provide some clear direction and answers.
I have been nervous to write a blog on this, because the info will be outdated almost as quickly as I can write it. I don’t like to add to confusion. I don’t like to add to angst. But, what I feel I must do is provide education, answers, and see if I can’t make this topic a bit less confusing and angsty.
First, the recent Federal Reserve rate hike. The Fed increased their rate 0.25%. The range is now currently 5-5.25%. This is not a shock. This was expected. Why is the Fed doing it? How does it help inflation?
The target inflation rate for an established economy/developed country is 2-3%. Jerome Powell has recently said that he is targeting 2%. The index that the Federal reserve uses to track that rate is the Personal Consumption Expenditure, or PCE. The current rate of PCE is 4.6% (as of 3/31, source: ycharts) Clearly that rate is much higher than the 2% Fed Chair Powell is targeting. We can anticipate rate hikes as long as we see such a strong disparity between the target inflation rate and the PCE. It’s a difficult balance for the Fed. No one wants high interest rates on their loans, but also no one wants to pay high prices for goods and services.
Higher interest rates decrease inflation. Regardless of personal feelings this is a true statement. That is why the Fed is raising rates. When things cost more money people buy less. That decreases demand, which in turn decreases prices, which in turn decreases inflation. Sadly, it’s not instant. This all happens over time. That is why the rate changes happen periodically. (I am sorely tempted to dive into an explanation of leading and lagging indicators. That would really get us into the weeds! Another day.) Bottom line, if the Fed goes too far it can cause a recession. They must make incremental changes so they can measure their effects and determine whether more hikes are needed, or if they should stop. Inflation has peaked and is coming down. The rates are around the level that the Fed hoped they could stop making hikes. We’ll see if they can stick to that at the June meeting. Based on Powell’s comments and the disparity between target inflation, and actual inflation, I’m sure you can guess where I’d play my chips.
Let’s move on to another question I hear and see a lot. Why should we address inflation? Why do we keep raising rates, and making it impossible for me to own a home? Let’s look at a real world and recent example of why we want to curb inflation, and why raising rates is an effective tool for that.
Q2 2020, the average price that a home sold for in the US was $374,500. Q4 2022 it was 552,600. (source STL Fed) That’s an almost 50% increase in just over 2 years! That’s bananas. That’s not sustainable or realistic. That’s inflation at work. Home prices got so high a lot of people had to stop shopping for a home. It’s not high interest rates that are making it impossible for you to buy a home. (btw, rates are still below their 40 year average.) It’s the inflation that came before the rate increases. Mortgage rates were so low that demand skyrocketed. Prices just went up and up. At low rates they would have continued to climb. We could take a Libertarian approach, and just let things play out naturally. However, that ends in huge catastrophes every time. EVERY TIME. Think Great Depression. That is what happens when inflation and growth go unchecked. They crash hard! Lucky for us our friends on the Federal Reserve Board stepped in. They started to raise rates. Demand for homes slowed. After a while prices started to come down. Prices are continuing to come down. Remember that these transitions do take time. Rate hikes started in Q1 2022. It took 3 quarters, almost a whole year, before inflation stopped growing and started decreasing.
Bottom line, we address inflation because people should be able to afford necessities. Let’s imagine you are a family of four that lives comfortably, not excessively, but you have enough for your needs and some wants. Now let’s imagine that the price of everything you buy increases by 3%. That may be your extra cushion. Now you are living paycheck to paycheck. Most of us have been there at some point in our lives. It’s so hard, and scary. If you have ever lived pay check to pay check you know it isn’t a far leap to not having enough to pay your bills. You spend a lot of time praying that nothing unexpected happens, because you can’t pay for it. Now, let’s pretend inflation goes up another 3%. You can’t pay your bills. You have to use credit cards to make ends meet. You don’t know how long you can go on juggling the shortfall from one card to another. You don’t know how long you can make it before you lose everything. You are creating debt instead of building wealth. Now, let’s stop pretending. This is what actually happened. Inflation was up over 9% at its peak. This is why inflation can’t just be ignored because you wish interest rates to borrow were lower. Full stop.
To close out, I’m going to look on the bright side. Not all inflation is bad. High inflation is bad, but not all inflation. Target inflation is 2% because without some inflation/growth we have a recession. In order to have a prosperous country we need inflation. Growth creates jobs. Growth creates wealth and opportunity. High inflation doesn’t last forever, but cost of living adjustments do. Eventually inflation will normalize. Prices will go back down, and your purchasing power will increase. Let’s look at some of the benefits:
1. Social Security COLA 8.7%, the avg. for the prior 10 years was 2.2% (source ssa.gov)
2. IRA contribution limits raised to $6500. These limits can stay stagnant for years. Thanks to inflation, we have seen increases a lot more frequently than in years past.
3. 401(k) contribution limits raised to $22,500. This one is significant. These limits also stagnate. Increases are usually $500-$1k. A $2k increase is unprecedented.
Inflation also causes pay raises, increases in your personal home price, increases in your investments, and the special sauce that allows us to give our children more than we grew up with.
There’s more that we could talk about in regards to inflation, a lot more, but I feel like that’s probably enough for today. Head over to the contact page if you have questions, or if I can help you to manage the swings of inflation.