Regardless of your financial condition, today’s economy is impacting you to some extent. Inflationary prices are costing you more for practically every good or service you purchase. Supply chain constraints may be limiting your access to certain goods. Rising interest rates are costing you more on consumer debt. These same rising interest rates are making it less appealing to borrow for purchases or capital expansion. Your investment accounts have taken a huge negative swing. Everyone is impacted to some extent, but not everyone is comfortable understanding how we got to this point nor what to expect in the future. It’s a complex problem, but let’s look at the basic components and make it as simple as possible.
One of the key terms we are hearing now is inflation. Inflation is simply the general increase in the cost of things. This increase in cost results in a decline in your money’s purchasing power. One of the keys to understanding what’s really going on with inflation is to understand the baseline comparison and know that small inflation (up to 2-2.5%) is normal for a growing economy. When you hear news reports of inflation going up 9%, understand that the report should generally be based on a year over year comparison for the given month (for example Aug 2022 compared to Aug 2021). The analyst will use a broad range of items to use in the analysis to fairly represent a cross section of the overall economy.
The key is to not only understand the year over year comparison, but to also understand the trend compared to the prior month’s comparison. While the current month’s inflationary percentage provides a good indicator of costs of goods compared to the same month last year, the trend provides a better indicator of what to expect going forward with respect to these costs.
Inflation simply occurs when an economy has too many dollars chasing too few goods. When the economy is full of available cash, the ability to spend will increase leading to increased costs for goods and services. Likewise, when the economy is short on goods and services, costs will also generally increase as these goods/services are likely in high demand. Put these two factors together, and one can easily see where costs would be higher. Demand (availability of cash) exceeding supply (shortage of goods/services) provides a strong environment for costs to go up!
So how did get to where we are today?
Issue 1: Go back pre-pandemic and recall that the economy was strong in the US. The pandemic hits, and many businesses shutdown or reduce production. Many people are not receiving the same level of earned income, and the government intervenes and provides several rounds of cash payments to people and businesses (stimulus funding). These payments no doubt meet some real needs but many of these payments also go to people that were still working and businesses that were still operating. Thus, we have a significant infusion of new money into the economy.
Issue 2: Many businesses are shutdown (deemed non-essential) and production for many items are reduced during early stages of pandemic. Other businesses are short-staffed for a variety of reasons and production declines in these additional areas as well. Supply chain issues across the country compound until we see a real shortage of goods/services in many areas. Workers are not wanting to return to the workplace for fear of sickness, available stimulus money provided without having to work, or any number of other reasons.
Issue 3: As pandemic concerns decline and businesses start back up, workers are still in short supply, and organizations are forced to compete for people with higher wages thus driving cost up. The government is still active in providing benefits during this period also, so workers have options that they didn’t have before pandemic occurrence.
Issue 4: As the overall economic demand appears to rebound quickly toward the end of 2021 going into 2022, supply chain shortages continue, wages have gone up, worker shortages persist, and now oil/gas prices are also starting to increase as US policy to limit expansion coupled with foreign supply concerns take shape.
Status: Stimulus money and government funding have the US economy flush with cash, even if everyone is not experiencing it to the same level. There is a continued shortage of goods and services in certain areas as overall production has not caught up to pre-pandemic levels in various segments. Global issues are providing unstable markets for some key items that we have a dependency on in the US. Thus, we have the perfect storm for high inflation.
What happens: The Federal Reserve (the national bank for banks) gets involved to curtail this inflation by using their favorite lever, raising interest rates to slow down economic growth, slow down spending, and essentially take some of this available cash out of the economy to bring costs down (thus reducing inflation). They want to take these actions slowly to not go too far with these rate increases and push the economy into a major recession. Recession is generally defined as a general economic decline that last more than a few months. It’s a loose evaluation methodology but is generally noted by increased unemployment (jobs decline), business expansion decline, and overall tough times for businesses and workers.
The other factor not mentioned is the stock market view of these interest rates rising. The market views interest rate increases unfavorably due to less economic expansion and will generally decline as interest rates increases. We are seeing that decline continue with the overall market down over 20% for many individual’s savings/investment plans. That’s a major concern to those who are dependent on these investment earnings in retirement.
There are a lot of moving parts right now in this complex system. While the system is complex (much more than I have even begun to discuss), the underlying issues are simple. We have too many dollars chasing too few goods. We have the Federal Reserve increasing interest rates to reduce inflation, but the trade-offs are problematic as well (higher consumer debt interest payments, stock market decline, etc.). The key is how to get back in balance without causing further disruption to the system. Too much intervention may not be a good thing. It’s a real challenge, but hopefully you have a general perspective of what’s going on, how we got here, and can start to think about how you can navigate through these challenging times.
