Who Has the Most Influence Over Inflation?
The Federal Reserve?
Kai Rysdaal on NPR’s podcast Make Me Smart commented on an article that asked that same question. Two-thirds of the respondents got it wrong. The correct answer is not the President nor Congress and it is not big companies or labor unions. The right answer is the Federal Reserve.
Allow me to clarify what inflation is and what causes it. Inflation is the rate at which prices (and wages) are increasing. Several years ago, the Federal Reserve targeted 2% for a sustainable rate that they feel is good for business and consumers. However, recent inflation reports put the current growth rate at closer to 8%. While it is great to think of company profits growing by 8% or getting an 8% pay raise or 8% cost of living increase to your Social Security check, the reality of higher food and gas prices is causing great hardships for many Americans, especially the poor.
The cause of inflation is simply too many dollars chasing too few goods….so prices go up. Or, from the other perspective, too many job openings and not enough workers...so wages go up. Right now, we have both. When Covid began in Spring 2020, companies slowed or even stopped production to keep workers safe and because of uncertain consumer demand for products…so less product for sale. Consumers, even those out of work, were flush with cash due to government stimulus checks, PPP loans, and limited options to spend…so lots of money to spend.
Today, many products are still in short supply…which leads to prices going up…i.e. inflation. There are two job openings for every worker in America looking for work…which leads to higher wages…ie. inflation.
What can be done and by whom?
The President has a couple of options that can make it look as if he is doing something. One is reducing tariffs on foreign goods so that Americans can buy cheaper foreign goods rather than more expensive American products or two is releasing some of the strategic oil reserve to maybe help gas prices. Both may help…but probably not much. Let’s hope he doesn’t try the wage and price controls implemented by Nixon in 1971. In the short-term, this policy looked good at the time plus it helped re-elect Nixon in 1972 but the damage to the economy took until the early 80s to overcome…see and please read the footnotes. (1, 2)
What about Congress? What can it do? The short answer is: not much. Granted, Congress could pass a sharp tax increase to knock down aggregate demand and tame inflation quickly. The tax increase would also necessarily have to be large enough to cause a sharp downturn in growth. Since “I Caused the Recession of 2022!” is not the campaign bumper sticker lawmakers are looking for, put that to the side. (3)
Big companies could reduce inflation by paying their employees less money or reducing the price of their products. Remember, inflation is about wages and the cost of products and services going up. Therefore, companies could pay less as well as charge less. Right? Ya, no! Employees would quit to work for competitors and shareholders would dump their stock and CEOs and Board members would also become sad.
Labor Unions are in the same place. They could tell their members to accept lower wages and fewer benefits….Ya, no! That won’t work.
The role of the FED is to maintain “full employment” and manage inflation while growing the economy. This is done by adjusting the interest rate they charge banks to borrow money. See the link in the video (5). When the FED charges banks more to borrow money, the banks charge their customer more on credit cards, car / home loans, as well as loans to businesses. When it costs more to borrow, borrowers are less likely to borrow as much and therefore spend less…therefore, demand decreases for products and services and inflation subsides. Please open the link and watch the two-minute video. (4, 5, 6)
To lower inflation, people need to buy less, employers need to hire less and layoff excess workers. Bottom line. We need to cool-off this red-hot economy. However, if the economy cools off too much too fast, the result may be a recession. This often scares people but it should not.
Economic cycles are like seasons. Summer becomes Fall, that transitions to Winter, Spring and back to Summer. Economic growth is good…but too much becomes inflation…which leads to higher interest rates that slows the economy to lower inflation...sometimes too much which leads to a recession. That leads to the next growth cycle…and around and around we go.
The stock market is not the economy and the economy is not the stock market. However, the market goes up to a new peak…then comes off that peak… then goes back to the old peak and beyond to create a new peak and then down…repeat the cycle. Higher than before, then lower, then higher than before. No guarantees are implied or made. This is just a look back at history. (7, 8)
Thank goodness the FED is independent of political pressure. The members of the FED are not elected and serve for fixed terms. The members are nominated by the President and approved by Congress…but after that politics is not part of the discussion. Despite the suggestions or feeling of the President and Congress, the FED has a job to do and historically they ignore pressure from politicians and have done what is needed for the economy. This has led to some monumental disagreements with both major parties hating the FED at different times when FED action seemed to have a potential influence on an upcoming election...i.e. LBJ, Nixon, Carter, HW Bush, Trump and ??? (9)
How will this impact you and what to do?
Financial planning is about managing cash flow and matching economic expectations to financial reality. A good rule is to only sell investments when you need the money. Not because you are fearful of the current financial situation. Buy when everyone is fearful. Pick your spots. Sell when it is good for you…meaning markets are up. If you don’t need the money today…I mean right now…then don’t sell.
Wollman Wealth Designs, Inc is a financial planning and investment advisory firm in Escondido, CA partnering with clients in San Diego County and around the country. Please call or email us with questions and comments.
Securities and advisory services are offered through Cetera Advisor Networks LLC (doing insurance business in CA as CFGAN Insurance Agency LLC), member FINRA/SIPC, a broker-dealer and registered investment adviser. Cetera is under separate ownership from any other name entity. CA Insurance License #0604093
"The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.