The March blog post offered a scenic tour of GDP, and why it’s an important economic measure for investors. Let’s continue the economics theme with inflation, which also gives us a chance to look at a conundrum that has been around for several years. Why does inflation remain so low when it should have started spiking a long time ago? Let’s start with some inflation basics, and then we can look at the dilemma.
What is Inflation?
In the 1930’s the US abandoned the gold standard, which gave the Federal Reserve or “The Fed” the ability to create and destroy money. This gives the Fed the ability to stimulate a weak economy, or slow a rapidly overheating economy. In fact, the Fed only has two jobs: manage unemployment and inflation. One of the downsides to this approach is that we’ll always have some persistent level of inflation over the long term.
Just a quick side note: the US should never return to the gold standard, never fall for that thinking.
Inflation is basically a sustained rise in the price of goods. For example: what you can buy for $1 today may cost you $1.03 next year as prices rise. The purchasing power of your dollar erodes. This isn’t as bad as it sounds because many employers will adjust wages with inflation to retain and attract employees, Social Security is adjusted for inflation, and some pension plans may adjust as well.
The Inflation Dilemma
During the “Great Recession” the Federal Reserve helped the US economy recover by keeping the basic market interest rate, that it controls, at near zero for years. They also purchased lots of bonds, and paid for those bonds with what were essentially newly created dollars. This was like “printing” trillions of dollars under the assumption that the Fed would need to remove this cash to prevent runaway inflation.
As the economy recovered markets expected to see inflation rise. It never happened. It has been ten years, unemployment is historically low, the Fed raised interest rates as the economy heated up, yet inflation has remained stubbornly and unexpectedly low. The vast majority of that newly created money remains in circulation.
The punchline: nobody really understands why inflation continues to run so low. This has left a lot of smart people scratching their heads and wondering what happened to inflation. Some like to blame the Fed, some like to blame globalization, some people blame it on issues with economic theory, and the list goes on.
For the average person this is not necessarily bad news. While some people have felt price increases on certain things, overall the cost of living hasn’t been rising uncontrollably. Welcome news for families on tight budgets, and retirees who may be on fixed incomes.
This does become a potential issue in the event of an economic downturn. We’re currently at the top of a long-term economic expansion, the next part of the cycle would be a recession. While predicting a recession is tricky business, when the time comes, the Fed will be forced to cut rates, and possibly create more new dollars, doing whatever it can to stimulate an ailing economy.
If inflation were to become deflation the economy would be in real trouble, fortunately, this is something that hasn’t happened in the United States since the Great Depression.
While deflation is highly unlikely, the fact that all known causes of inflation have occurred, and we still haven’t seen it, has economists and market watchers wondering what changed, which is rare, and makes this interesting.
So as this question of inflation gets tossed around, know that for every theory you hear, there are at least two or three others that could also be convincing. The mystery may not be solved anytime soon, but hopefully, at some point in the future, researchers will be able to tell us what happened and why.
If you would like to understand more about anything in this post, or how inflation at any level impacts your investments please do not hesitate to reach out!
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