Inflation’s Impact on Wealth – Part 1

Much has been made about the Federal Reserve’s recent monetary policy changes. The questions that needs to be asked are, “What does this new policy mean and how does this impact me?”

What is the Federal Reserve?

For those not familiar with the Federal Reserve, let’s discuss the role of the Federal Reserve and how they impact the economy.

Per Wikipedia, the Federal Reserve (aka The Fed) is the central banking system of the United States and is run by a presidentially appointed board of governors (aka The Federal Reserve Board) . There are 12 regional banks spread throughout the United States that oversee and regulate the private commercial banks in each region.

Nationally chartered commercial member banks are required to hold stock in and can elect 6 of the 9-member board of directors of each Federal Reserve region they are located in (other 3 are appointed by the board of governors). Member banks also earn dividends on this stock. This stock cannot be pledged as collateral for loans or be sold on the open market.

What this means is that although the Federal Reserve’s Board of Governors are appointed by the president and is considered a government agency, the Federal Reserve system is not.

The regional banks are actually setup like private corporations. The Federal Reserve system considers itself an independent central bank because its monetary policy decisions do NOT have to be approved by the President or any member of the executive / legislative branch of government. The Federal Reserve does not receive congressional – appropriated funds and the term length of the board of governors are staggered and spans multiple presidential terms.

The main objective of The Federal Reserve is to manage the nation’s monetary policy.

Monetary policy is set by the Federal Open Market Committee (FOMC) and consists of the seven members of the board of governors and the 12 regional Federal Reserve Bank presidents.

Monetary policy is controlled through 3 main objectives:

  • Price stabilization
  • Maximizing Employment
  • Maintaining long-term economic growth through moderating interest rates

inflation targeting

In addition to those, The Fed’s duties have expanded in recent years to also include regulating banks, maintaining financial system stability, and conducting economic research.

The goal of the Federal Reserve System is to promote stable prices. When prices are stable, consumers and producers can make long-term spending and investing decisions without worrying if the value of their money will significantly change in the near future.

The ability to maintain stable prices is a long-term measure of the Fed’s success. This is achieved by controlling the amount of money circulating in the economy, the level of reserves held by banks, and the federal funds rate banks charge each other.

Monetary policy is controlled by the FOMC through the setting of a target for the federal funds rate (the rate banks can charge each other for overnight loans to meet minimum reserve requirements) and attempt to hit the target by buying and selling government securities through the use of open market operations.

Open market operations work in that the Fed doesn’t decide on the securities dealers it will do business with. Instead, various securities dealers compete in the open market based on price. The Fed uses open market operations to arrive at the target federal funds rate.

The federal funds rate is important because movements in the rate influence other interest rates in the economy. If the federal funds rate lowers, it is likely that the prime rate, home loan rates, and car loan rates will also lower.

By raising or lowering the federal funds rate, the entire U.S. economy can be impacted since the entire economy is dependent upon 2 things: money flowing through the economy and credit. Money flows back and forth between banks who loan out the money and businesses who want a loan to continue expansion. Credit is used to extend loans to people and businesses deemed “a low risk of loan default”.  If either of these slow down, the economy slows down.

Experience has shown that the economy performs well when inflation is low because interest rates typically are low as well.

Low interest rates allow businesses to borrow money for expansion. Businesses hire additional workers and expand operations which allow secondary workers to be hired since they are needed to build these expanded operations. This environment promotes low unemployment, allows the economy to grow, and if managed correctly, prices to slowly increase over time. Growing prices over time is otherwise known as inflation.

Inflation on the Other Hand………….

In simple terms, inflation is the decline of a currency’s purchasing power over time. The decline in purchasing power can be measured by the rate at which the prices of consumer goods increases. In other words, the same amount of money buys less goods and services over time.

inflation targeting

Inflation can be both good and bad depending upon how it is managed. If managed correctly, a modest inflation rate over time can be good for the economy. If mismanaged, inflation can literally send the economy into a downward spiral that can be very difficult to get out of.

If inflation has been at a low, steady, and predictable rate for many years, say a 2% rate for the last 10 years, both consumers and producers expect this to continue and plan accordingly.

However, what if inflation is wild and unpredictable? For example, let’s say the inflation rates are as follows:

Year 1 = 2%

Year 2 = 9%

Year 3 = 14%

Year 4 = 1%

Year 5 = 5%

This would make it extremely difficult to know how to save, spend, or invest money now and in the near future.

Causes and Types of Inflation

Per Investopedia, the cause of inflation is due to an increase in the money supply. The money supply can be increased several ways such as printing more money, giving away money to individuals, by legally devaluing the currency, and loaning new money into existence through the purchasing of government bonds on the secondary market.

There are 3 basic mechanisms for how inflation is created:

  • Demand-Pull Inflation
  • Cost-Push Inflation
  • Built-In Inflation

Demand-Pull Inflation

Demand-pull inflation occurs when an increase in the money supply and in overall credit stimulates demand for goods and services to increase more rapidly than the economy’s production capacity. Demand increases and leads to higher prices.

For example, say the economy is in a boom period and unemployment rate is at record lows. The government issues tax credits for purchasing electric vehicles which now makes it cheaper to buy than conventional gas-powered vehicles.

Demand for the electric models ramps up quickly and unexpectedly. The OEM’s cannot produce the cars in sufficient quantities to meet this surge in demand. The price of these new vehicles increases drastically which makes finding a bargain tough if not impossible.

Cost-Push Inflation

Cost-push inflation occur when costs of producing a good or service increases the final price a consumer pays. For this to take place, demand for the affected product must remain constant during the time the production costs are occurring. To maintain profit margins for this constant demand, producers raise the price the consumer pays.

Back to the electric vehicle example, let’s assume the raw materials to produce the electric battery (the most expensive part on the vehicle) suddenly doubled in price. Demand remained constant but profit margins took a big hit. To compensate for this, the OEM raises the price of the car to offset the loss in profit margin.

Built-In Inflation

Built-In inflation is the idea that people expect current inflation rates to continue in the future. As the price of goods and services rise, the expectation is that it will continue to rise in the future at the same rate. To maintain their standard of living, people demand more wages. These increased wages result in a higher cost of goods and services and the cycle continues.

How the Fed is Controlling This

The Fed constantly measures the effects of its policies on the economy. The Federal Reserve had setup a goal for inflation to run at the rate of 2% year over year. Overall, there may be slight fluctuations, but it should average, and has averaged, 2% in the long run.

Recently, the Fed has changed its policy on how to measure the target inflation rate.

Instead of a specific rate of 2%, the Fed has shifted to an average rate of 2% over a period of years. This “average inflation targeting” will allow for a looser monetary policy. The idea is that when inflation undershoots the 2% target rate for a period of time, the FOMC will adjust its monetary policy to push inflation above the 2% target for a period of time to compensate for this.

The Fed did not specify over what period of time they will seek to have an average 2% inflation rate nor how much above 2% are they willing to go to balance out and make-up for the undershoots. The Fed also did not specify how or what tools they will use to do this.

This latest strategy shift means the Fed will be less inclined to increase interest rates when the unemployment rate falls (currently hovering around 6.2% nationwide and down from the 14.7% rate at the start of the pandemic), as long as inflation does not creep up too high.

In the past, the Fed believed that low unemployment would lead to dangerously high levels of inflation and would preemptively head it off. The fear was that if unemployment fell too low, the economy would overheat and lead to runaway inflation. Now, they are willing to let the economy “run hotter” than they were willing to before.

What happened to cause this change in policy?

For years now we have had a very low unemployment rate AND a relatively low & stable inflation rate. Based on their past philosophy, we should have already entered an inflationary cycle from the low point of the 2008 recession….. yet we haven’t. Why?

According to William English, a Yale professor and former Fed official, this policy change reflects structural changes in the economy that have happened over the last 20 years or so. These policy changes should enable the Fed to better manage unemployment volatility and potential economic downturns as we are coming out of this pandemic.

As we left the Great Recession, the economy hit a several year point in which growth was weak and inflation very low.

As we leave the pandemic in the coming months and the world gets back to some semblance of normalcy, this much is certain: our lives will be forever changed.

The use of WebEx and Zoom has changed that way we do business. Corporations are realizing that all the office space that has been accumulated probably isn’t needed as much as originally thought. I know of several corporations looking to sell their office space since they realized their workers are just as productive working from home as they were in the office.

Restaurants that do not offer carryout and online delivery are quickly dying out.

How we shop has also changed. Online ordering trends have exponentially accelerated and several traditional brick and mortar stores that did not have a strong online presence have either died out or on the way to becoming insolvent.

What’s next? What happens to all of the jobs being lost? How will the economy generate new jobs to offset these losses?

How Does Inflation Targeting Help?

Want to understand how inflation targeting helps this dilemma? Want to learn about how this new strategy can impact your wealth and economic future? Want to learn about how you can compensate so that your portfolio can minimize potential losses? Then tune into next week’s article…. you won’t want to miss it! 😊