High inflation is fueling economic worries: How the Fed’s latest rate hike fits in

What’s up

Inflation hit a record high in the US last month. In response, the Fed raised rates for the fourth time this year. Economists now fear that a recession, or even stagflation, is a high risk.

why does it matter

Stagflation, a rare combination of high inflation and high unemployment, devastated the US economy in the 1970s and early 1980s.

what does it mean to you

Rising prices mean gas, food and necessities are more expensive, and a sluggish economy means it’s harder for Americans to earn money, secure jobs and save.

In an attempt to quell runaway inflation, the Federal Reserve raised the federal funds rate by another 75 basis points on Wednesday. In June, inflation rose 1.3% to a 12-month rate of 9.1% – the highest level of inflation since November 1981, according to the Consumer Price Index report. This latest rate hike marks the Fed’s fourth rate hike of the year.

While containing inflation is the Fed’s main objective at the moment, many financial experts fear that raising rates too aggressively and too quickly could send the economy into a tailspin. recession. Or, if inflation remains high as unemployment rates start to rise, the US could find itself in a period of stagflation.

What does all this mean, exactly, and should you be concerned? Let’s break down what inflation is, how we got to this point, and explain the difference between recession and stagflation. Here’s everything you need to know about rising prices and where the economy might be going.

What is inflation?

Simply put, inflation is a sustained rise in consumer prices. That means a dollar bill doesn’t give you as much as it used to, whether you’re in the Bomboneria or a used car lot. Inflation is often caused by rising demand (such as COVID-cautious consumers finally ready to leave their homes and spend cash) or supply-side factors such as increases in production costs and supply chain restrictions.

Inflation is a long-term datum, and it requires historical context to mean anything. For example, in 1985, the cost of a movie ticket was $3.55. Today, watching a movie at the theater easily costs $13 just for the ticket, no matter the popcorn, candy, or soda. A $20 bill in 1985 would buy nearly four times what it buys today.

Typically, we see a 2% inflation rate from year to year. It is when the rate rises above this percentage in a short period of time, as it did throughout 2022, that inflation becomes a concern. As salaries do not follow exorbitant prices for basic products and more companies start layoffsUS households, particularly low-income Americans, are feeling heavy financial pressure on their wallets.

Right now, Gasolinefood and housing are the biggest drivers of our current high levels of inflation. However, prices are on the rise across the board. Even outside the “inflation core”, health care price indices, car insuranceclothing, home furniture and recreation rose last month.

What is a recession?

The slowdown in the US economy during the first quarter of 2022 raised concerns of a recession. This refers to a period of prolonged economic decline and market contraction, where the unemployment rate rises and production declines, often slowing inflation.

Looking back past US recessions tells us that during a period of recession, unemployment rates tend to rise and goods prices begin to fall. It is generally more difficult to obtain financing during a recession as banks tighten their requirements to minimize the risk of lending to borrowers who may default.

And stagflation? Is it the same as recession?

Stagflation, on the other hand, refers to a period when a recession is uniquely associated with high inflation. According to the Bank of America’s June fund managers survey, 83% of investors expect a period of stagflation in the next 12 months.

A mixture of “stagnation” and “inflation”, the term “stagflation” was coined in 1965, when British politician Iain Macleod bemoaned the country’s widening gap between productivity and earnings: “We now have the worst of both worlds – not just inflation on one side or stagnation on the other, but both together. We have a kind of ‘stagflation’ situation and history in modern terms is indeed being made.”

Stagflation became best known during what became known as the Great Inflation in the US in the 1970s. As unemployment reached 9% in 1975, inflation continued to rise and reached over 14% in 1980. Memories of this dark economic period added to current fears about runaway inflation.

Today’s economic circumstances have some parallels with the 1970s, but also major differences. During the energy crises then and today, a supply chain disruption helped fuel inflation, followed by a period of relatively low interest rates in an attempt to expand the money supply in the economy. Unlike the 1970s, however, both the dollar and the balance sheets of major financial institutions are strong. The official US unemployment rate also remains low, currently at 3.6%, according to the Bureau of Labor Statistics.

When do we know we are in a period of inflation?

Inflation is not a physical phenomenon that we can observe. It’s an idea supported by a consensus of experts who rely on indices and market research.

One of the most closely watched indicators of US inflation is the Consumer Price Index, which is produced by the Bureau of Labor Statistics and based on urban shoppers’ diaries. CPI reports track data for 80,000 products, including food, education, energy, healthcare and fuel.

The BLS also assembles a Producer Price Index, which tracks inflation more from the perspective of consumer goods producers. The PPI measures changes in sales prices reported by sectors such as manufacturing, agriculture, construction, natural gas and electricity.

And then there is the Personal Consumption Expenditure price index, prepared by the Bureau of Economic Analysis, which tends to be a broader measure because it includes all goods and services consumed, whether they are purchased by consumers, employers, or federal consumption programs. side.

The current inflationary period generally began when the Department of Labor announced that the CPI increased by 5% in May 2021, following a 5% increase in April 2021 – an increase that caused a stir among market watchers.

While a rise in the CPI alone doesn’t mean we’re necessarily in an inflation cycle, a persistent rise is a worrying sign.

How did we get such high inflation in the first place?

Today’s inflation was originally categorized as “transient” – considered temporary as economies recover from COVID-19. US Treasury Secretary Janet Yellen and economists have pointed to an unbalanced scale of supply and demand as the cause of transient inflation, triggered when supply chain disruptions converged with high consumer demand. All this had the effect of driving up prices.

But as the months passed, inflation began to seep into parts of the economy originally untouched by the pandemic, and production bottlenecks persisted. The US was then hit by shocks to the economy, including subsequent variants of COVID, lockdowns in China and Russia’s invasion of Ukraine, all leading to a choked supply chain and soaring energy and food prices.

“I think I was wrong about the path that inflation would take,” Yellen told CNN in late May. “There were unforeseen and major shocks to the economy that drove up energy and food prices and supply bottlenecks that severely affected our economy that I didn’t understand – at the time – I didn’t fully understand, but we recognize that now.”

How can the Federal Reserve try to alleviate inflation?

The Fed, created in 1913, is the control center of the American banking system and administers the country’s monetary policy. It is made up of 12 Federal Reserve regional banks and 24 branches and is managed by a board of governors, all of whom are voting members of the Federal Open Market Committee, which is the Fed’s monetary policy-making body.

While the BLS reports on inflation, the Fed moderates inflation and employment rates by managing the money supply and setting interest rates. Part of its mission is to keep average inflation at a constant 2% rate. It’s a balancing act, and the main lever it can pull is adjusting interest rates. In general, when interest rates are low, the economy and inflation grow. And when interest rates are high, the economy and inflation slow down.

The federal funds rate is the interest rate that banks charge each other for loans and loans. When the Fed raises that rate, banks pass that rate increase on to consumers, driving up the overall cost of borrowing in the US. Consequently, this often leads consumers, investors and companies to pause their investments, rebalancing the supply and demand scales disrupted by the pandemic.

Raising interest rates makes it more expensive for businesses and consumers to borrow, which means buying a car or a house will be more expensive. Additionally, bond and cryptocurrency markets can also be negatively affected by this: as interest rates rise, liquidity in both markets declines, causing markets to plummet.

With rates well above the 2% inflation target, the Fed reacted raising rates by a quarter of a percentage point in March, half point in May, three quarters of points in June and another three quarters of points this month. The Fed noted that we are likely to see more rate hikes this year – up to six in total.

What about deflation, hyperinflation, contraction?

There are a few other “flations” worth knowing about. Let’s brush.

Deflation

As the name implies, deflation is the opposite of inflation. Economic deflation is when the cost of living drops. (We saw this, for example, during parts of 2020.) Widespread deflation can have a devastating impact on an economy. Throughout US history, deflation has tended to accompany economic crises. Deflation could portend an impending recession as consumers tend to stop shopping in the hope that prices will continue to fall, thus creating a slump in demand. Eventually, this leads to consumers spending even less, lower wages, and higher unemployment rates.

hyperinflation

This economic cycle is similar to inflation in that it involves an increase in the cost of living. However, unlike inflation, hyperinflation occurs quickly and is out of control. Many economists define hyperinflation as rising prices by 1,000% per year. Hyperinflation is uncommon in developed countries like the US. But remember Venezuela’s economic collapse in 2018? This was partly due to the country’s inflation rate which reached over 1,000,000%.

Shrinkage

Tangentially related to inflation, contraction refers to the practice of companies to reduce the size of their products while maintaining the same prices. The effect is identical to inflation – your dollar has less purchasing power – and it becomes a double whammy when your dollar is already weaker. Granola bars, liquor bottles and toilet paper rolls have all been caught shrinking in recent months.

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