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Inflation has become a widely discussed topic on the news and even other media programs, but what is the impact of higher levels of inflation and how has it created a dilemma for the FED? Here we’ll explore this topic in more detail.
The Inflation Surprise: The FED Didn't See It Comes
In recent years, many of us have become comfortable with the idea that economic experts will be able to forecast inflation rates. So, when inflation skyrocketed, it was an unexpected surprise. And here's the truth: no one knows what exactly happened and why the inflation surprisingly increased.
However, there are several reasons that may impact
The first was the 2020 Covid pandemic and the subsequent variants. In 2021, Jerome Powell, the Fed Chair blamed the Delta covid variant for slowing down the reopening of the economy and fuelling increasing inflation.
The pandemic also exacerbated the supply chain issues, which blew up the inflation forecasts. The pandemic caused a number of bottlenecks in the production networks, since only key workers were continuing as normal and non essential personnel were staying in their homes to prevent contagion.
However, many experts believe the real reason for the inflation surprise is the drastic increase in FED balance sheet. Since 2008, the total public debt rose from about 8T to over 30T dollars, and when you inject so much money to the market with the lowest interest rates ever, inflation is inevitable.
There were also economic models which provided reason to believe that there were several factors including premature deaths, the covid 19 economy hardening costs and reduced immigration which would reduce the US economy potential in 2021. These constraints suggested that additional demand would push inflation upward.
Why High Inflation is Dangerous to the Economy?
The main danger of high inflation is that it reduces the purchasing power of the currency. This not only impacts consumers within the country, but it also affects international trade. As buying power is reduced, the quality of living for consumers is reduced. It can end up in a situation where people cannot afford to feed themselves and keep their homes warm in winter.
A good example of this is in post World War I Germany. The impact of the war along with the international protective tariffs and reparations led Germany into a state of hyperinflation. Inflation reached a point where millions of German marks were essentially worthless. There were cartoons at the time, which depicted people using a wheelbarrow of money to try to buy a loaf of bread.
Inflation can also be a driving force in the development of a recession. As inflation pushes up interest rates and increases the cost of living, economic activity slows, which can trigger a recession.
For example, in the 1980s, inflation reached a massive 22%. Interest rates were sky high and the U.S and many other countries around the world entered a three year recession. During this time, inflation remained high and unemployment figures went through the roof. It took almost half a decade for the U.S to recover from this economic downturn.
How the FED Tries to Cool Down the Market?
Since out of control inflation is highly detrimental to the economy, the FED tries to cool down the market and get the rate of inflation back in check. The strategy for this is to increase interest rates. By increasing interest rates, the FED is trying to slow down the economy and thereby reduce inflation.
Throughout 2022, the FED made several changes to the Federal Funds Rate. These incremental changes were up to 75 points and occurred every one to three months. This was a cautious strategy to make small changes and then verify the impact to assess the need for another adjustment.
Essentially, this meant that when the Federal Funds Rate was increased, interest rates in the banking sector also increased. While this provided a boost for savers, the primary objective was to slow lending and borrowing. The costs for personal loans, mortgages and even credit cards were affected, which forced consumers and businesses to take a more cautious financial approach. As borrowing and spending is reduced, it is anticipated to force inflation rates back down.
Of course, the FED cannot simply apply a massive rate increase, as this could cause the economy to completely stall. So, the tried and tested method is to make incremental smaller changes, waiting to see if there is a measurable effect, once the rate increase has trickled down into the wider economy.
The Problem: Inflation isn’t Cooling Enough
There is an argument that the FEDs approach was too little, too late. Many economic experts argue that the FED should have intervened earlier and waited too long to start implementing changes to the Federal Funds Rate. There was also some skepticism that starting out with a measly 0.25% rate increase would not jumpstart a downward inflation trend.
In fact, there was a narrative from FED officials that we were experiencing “transitory” inflation, which would correct itself without intervention. Unfortunately, during this time, wages could not keep up with soaring prices and financial experts began to question whether the FED was sleeping on the job.
Of course, the inflation rate has not been helped by supply chain issues and the international uncertainty caused by the conflict in the Ukraine.
However, recent FED statements indicate that FED Chair, Jerome Powell is taking the matter very seriously and we should expect the FED to announce more “forceful steps” in the coming months to really tackle bringing down inflation.
Why Higher Rates Can Be Dangerous?
The real danger of continuing high rates of inflation is that there will be a massive spike in interest rates. When this occurs, it can have a serious impact on consumers and businesses. Higher interest rates not only reduce consumer spending, but increase the risk of defaults and bankruptcies.
These mean that financial institutions may be forced to write off debt, which can put them at risk. This happened in the last financial crisis when a number of banks and financial institutions required a government bail out to continue trading.
The overall aim of the FED and economists is that we would experience a soft landing. Essentially, this is a slowdown in economic growth, which manages to avoid a full blown recession. In a soft landing, there would be a gradual slow down, which allows interest rates to reach a point just high enough to stop the economy from overheating, but without causing a complete shutdown.
Unfortunately, many economists agree that the window for a soft landing is closing rapidly. This means that a recession is looking likely. So, we could be facing a period of declining sales, cost cutting measures and higher unemployment. However, depending on how the FED handles its dilemma, the severity of the recession could vary from significant to very mild.