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Key Takeaways
- Inflation has been much higher than the 2% target since early 2021.
- Though inflation is on a downward trend, it remains to be seen whether that trend will continue.
- The Federal Reserve seems committed to fighting inflation, even at the risk of causing a recession.
2022 has been a year of economic uncertainty. One of the major contributing factors to that uncertainty has been inflation. In the U.S., inflation has far outpaced the Fed’s typical 2% target since early 2021.
Though inflation has eased somewhat in the last few months, it is still quite high, leading many people to worry about future price increases.
Background
Inflation is the process through which money loses purchasing power over time. You’re probably familiar with it through stories from your grandparents where they complain that bread used to cost a nickel.
In general, economists believe that low, stable levels of inflation are good for an economy. Slight inflation encourages spending, which keeps the economy moving.
Traditionally, the U.S. Federal Reserve aims to keep inflation at about 2% annually. The Fed believes this level of inflation strikes a good balance between keeping prices stable and encouraging economic growth.
Since about 1992, the Fed has done a good job of managing inflation and maintaining the rate at about 2%. Inflation went up and down but never rose too far above 2%. It hit a high of 3.45% in 2005 but overall averaged 2.3% from 1992 to 2021.
2021 saw inflation begin to rise far above the 2% target. In April of that year, inflation reached 4.2%. It continued to rise through 2021 and into 2022 when it peaked at 9.1% in June.
Inflation impacts different industries differently. Some of the worst-impacted areas have included essential expenses, such as gas, motor vehicles, and transportation. That means that all consumers have felt the squeeze of higher prices.
What is Causing Inflation?
Inflation is complicated, because there are so many factors that can influence it.
Supply Chain Problems
The COVID-19 pandemic saw the world’s economy grind to a halt as governments instituted lockdowns and travel hubs shut down. In today’s incredibly interconnected economy, shutdowns in one part of the world will impact other regions.
Shipping prices have increased considerably, and fuel costs have exacerbated that issue, contributing to higher prices.
OPEC
OPEC is a multinational group that controls a large percentage of the world’s oil production.
The group recently announced that it would reduce the production of oil by 2 million barrels per day, its largest cut since the beginning of the pandemic.
OPEC claims that this cut is to reduce volatility in oil prices, but the reduction in supply has significantly increased fuel prices.
Corporate price hikes
Many politicians and economists have claimed that corporations are raising prices because of inflation. This makes sense. As goods become more expensive to produce, companies must charge more for them.
However, many claim that the price increases are only partially due to higher production costs and that companies have used inflation as a cover to boost their profits. A report from the New York Times has found that more than 2,000 companies have seen greater profit margin increases this year than their pre-pandemic averages.
Monetary policy
The Federal Reserve is responsible for managing the money supply in the U.S. economy. For the past 15 years or so, the Fed has kept interest rates incredibly low, typically near 0%, which has encouraged borrowing and spending.
Some economists argue that this long period of loose monetary policy increased the money supply by too much and has contributed to current inflation.
The Russian invasion of Ukraine
Russia’s invasion of Ukraine caused turmoil in the global economy and contributed to inflation in a few ways.
For one, Russia is a major supplier of oil and other natural resources to Europe. With many European countries refusing to do business with Russia, prices have increased.
Ukraine is also a major exporter of food. Its exports have understandably gone down during the war, leading to price increases.
Going forward
It’s hard to know where inflation is going from here. Though it has been on a downward trend in recent months, an uncontrollable or unpredictable event could happen, causing it to rise again.
The Federal Reserve seems to be quite committed to fighting inflation at almost any cost. Jerome Powell, the chairman of the Federal Reserve, has noted that “no one knows whether this process will lead to a recession or, if so, how significant that recession would be. We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.”
In short, the Fed will do what it takes to stymie inflation, even if it means sending the economy into a downturn.
At their recent December meeting, the Federal Reserve announced that it expected to continue raising interest rates through 2023. That might imply that the Fed sees inflation as remaining high through at least the end of next year.
The same announcement noted that the Fed does not expect rates to return to the neutral benchmark of 2.5% until 2025, so we might be waiting quite some time before rates return to normal.
What it means for investors
For investors, keeping an eye on inflation is important. High inflation rates make fixed-income securities and cash a bad investment. If you have a bond with a 5% interest rate and inflation is 6%, you’re losing money rather than making it. Similarly, your cash is slowly losing spending power.
Instead, investors should try to hold securities that benefit from inflation. Stocks are one good way to hedge against it. Companies typically increase prices with inflation, which boosts profits and stock prices. Real estate is also a popular hedge against inflation.
Risk-averse investors could consider Treasury Inflation-Protected Securities (TIPS). TIPS are a type of bond that regularly adjusts its interest rate for inflation on a regular basis.
Final word
Inflation is a tricky problem because it’s impacted by so many different factors. The Federal Reserve is committed to fighting today’s high inflation, but signs are pointing to another year or more of price increases and a potential recession before inflation gets under control.
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Source: https://www.forbes.com/sites/qai/2022/12/27/when-will-inflation-stop-will-rising-prices-and-rate-hikes-continue-in-2023/