Turn on the news or pick up a newspaper and you will no doubt soon hear or read about inflation and its twin brother, rising interest rates. Both are rising quite rapidly and are bringing with it a lot of unease and anxiety. If you are like most people, you probably have a lot of questions and are having a hard time finding a reliable source of information.
What is Inflation and Why are We Experiencing It?
Inflation means prices for goods and services are getting more and more expensive. The economy is too complex for anyone to say with certainty exactly what is causing it, but in general there are just not enough goods and services to go around to everyone who wants them, so the prices go up.
Keep in mind that the major parts of the global economy came to halt during the Covid pandemic, and a lot of production was shut down. It takes a while for all of the related shortages to work through the financial systems.
The current situation with the economy is a bit like driving on a congested freeway during rush hour. If one car hits the brakes, it starts a chain reaction of each car behind it hitting their brakes, and it can take hours for all the braking to dissipate out of the system.
The global economy is like that highway right now. Most of the hazards that caused the braking are gone, but some cars still need to slam on the brakes to keep from hitting the car in front of them. In the economy, many businesses are ready to get back to maximum production after Covid shutdowns, but their customers and clients are still not quite ready to place orders, and it will likely take months for things to be able to ramp back up to full speed.
All of that congestion in the economic system is causing shortages of goods and services, making them more expensive. So we know it’s going to take a while for the economy to get back to normal, and recent data suggests we have already passed an inflection point and things are getting better. Inflation hit a whopping 8.3% in March and that may have been the peak. It is still quite high, but it is likely on its way back down.
Why are Interest Rates Rising?
The Federal Reserve Bank can partially control inflation by raising and lowering the interest rate that banks use to lend and borrow money to each other. As interest rates rise, economic investment slows which should lead to a decrease in inflation.
This slowing down of the economy does come with a cost to it as well. For people who, for example, are in the market to buy a new home, they will see that mortgage rates and monthly housing payments will rise, and sometimes quite significantly. Since more money is going towards paying the interest on the loan, there is less available to pay the principal. So as you can see, it leads to lower housing prices, and many other goods and services as well.
The Federal Reserve Bank has indicated that they will continue to increase interest rates by 0.5% roughly every six weeks throughout 2022. This will cause prices of goods and services, especially housing, to decrease. Now this may sound good, but the cost to borrow money will increase. This is why things like mortgages will become more expensive.
Rising rates decrease inflation because there is less money in the economy due to banks giving out fewer loans. So while prices may drop, there will be less money to go around as well. Bottom line, it is going to take a few months yet for the economy to stabilize due to pandemic related disruptions.
While this may sound scary, it is important to note the Federal Reserve has not indicated they plan to raise rates to historically high levels. We have enjoyed extremely low rates for some time now, and the announced increases only take them up to historically average levels.
We have been through many cycles like this in the past, and we have always recovered, and in this case, data does suggest we have already passed an inflection point and inflation is at least leveling, albeit at a high level. In other words, we may already have seen the worst of things regarding inflation.
- There are simply not enough goods and services available for everyone who wants them right now. Many or the shortages are likely caused by pandemic related shutdowns during the past two years.
- The Federal Reserve Bank raises interest rates in an attempt to slow down the economy so that the backlog of goods and services can be filled.
- The Federal Reserve Bank has stated they plan to keep raising interest rates throughout the year.
- Higher interest rates means higher monthly mortgage payments for most home buyers. These rates will likely push home prices down, or at the very least keep them from rising further.
- While rates are indeed rising, it should be noted that they are only rising from historically very low to average. The Federal Reserve Bank has not indicated in any way that they will raise rates to what would be considered historically high.