In April 2022, after the Federal Reserve made its first rate increase in about 3 years, we suggested some financial moves to take advantage of still low interest rates at the time. We’re now revisiting the inflation and interest rate conversation for two reasons:
- We’ve received several questions about how interest rate policies affect inflation, and
- With a recent decrease in inflation, we believe it’s time to discuss financial strategies for a more normal inflation environment.
Read on to understand why we’ve had a period of inflation, how the Federal Reserve has attempted to combat that inflation, and what we could expect in the near future.
Inflation Defined
Inflation is the rate at which prices increase over time, and is measured on an annual basis. For example if the price of something that costs $100 today increases to $105 a year from now, we say that item experienced price inflation of 5% over that year.
Prices can also decrease in periods of deflation. For example, if something that costs $100 today costs $95 in a year, the price will have deflated by 5%, and the seller will receive $5 less for the same product than they would receive today. Inflation is typically measured with the Consumer Price Index (CPI), which tracks changes in price of a basket of goods and services.
Inflation, rather than deflation, is the typical state of things. A mild inflation rate means that our economy is steadily growing and typically indicates that wages and prices are both increasing steadily from year to year. The Federal Reserve is tasked with keeping inflation at about 2% annually. When it deviates from this target substantially, the Federal Reserve might adjust interest rates in an attempt to bring the rate of inflation back to that 2% target.
We’ll explore how the Federal Reserve influences the rate of inflation in just a moment, but first let’s investigate why we’ve had a period of high inflation from 2021 through 2023.
Why We’ve Recently Experienced High Inflation
Multiple factors can influence inflation, but ultimately, it’s the result of increased supply of money and the increased demand for goods relative to the supply available. Both of these factors contributed to high inflation over the last 15 months.
Increased Money Supply
We use money to purchase goods and services. When there is more money in circulation to pay for those same goods and services, prices go up. That’s inflation.
To combat potentially devastating consequences during the COVID pandemic, both federal and state governments provided unprecedented financial assistance to individuals and businesses. These programs buffered our economy during a challenging time. But, as we entered a more normal economic environment post-COVID, we had an increased money supply which meant that we had more money to spend on goods and services. This caused inflation.
The Federal Reserve tries to influence the rate of inflation by making changes to the money supply. We’ll discuss this more in a moment.
Demand for Available Goods
Another factor that fueled inflation recently is an increase in demand for goods and services relative to the supply available. If people are willing to pay more for goods and services when they’re in short supply, then prices will go up.
During COVID, many manufacturing companies experienced complications with production which reduced the supply of needed products, but there wasn’t as much demand during the height of the pandemic. As we entered a more normal environment post-COVID and demand for goods and services increased to normal levels, prices for these limited products increased.
While either one of these forces would cause inflation on their own, since March 2020, we’ve experienced both simultaneously. As a result, the rate of inflation increased from 0.1% in May 2020 to 9.1% in June 2022 as shown in the chart below by the Bureau of Labor Statistics. An inflation rate of 9.1% is well above the Fed’s target of 2.0%.
So how does the Federal Reserve influence the money supply and manipulate the rate of inflation?
Federal Reserve Inflation Policy
The Federal Reserve influences the money supply by affecting interest rates. Specifically, they adjust what’s called the “Fed Funds Rate,” the rate at which banks borrow money from each other. Banks must charge consumers more than they pay to borrow from other financial institutions.
If the Fed Funds rate increases, and banks pay more to borrow money, then they pass this cost along to consumers by charging higher interest rates on loans. Because consumers are paying higher rates to borrow money, they have less money to spend on other goods and services. This decrease in money suupply reduces inflation. When the rate of inflation decreases to the target 2%, the Fed is likely to stop their rate increases. Currently, the rate of inflation is about 3%.
If the Fed overshoots its target and inflation drops below 2%, they might even decrease the Fed Funds rate to try to cause overall interest rates to decrease and thus increase the money supply in an attempt to get inflation back up to 2%.
Recent Changes in the Fed Funds Rate
It was when inflation reached a rate of 8.5% in March 2022 that the Federal Reserve made its first Fed Funds rate hike, and they have aggressively increased the rate since then. At the time, the rate was 0.08%. Through incremental increases, the Federal Reserve has brought the Fed Funds rate up to a current rate of 5.12%. This policy affectively helped to bring inflation down from a high of 9.1% in June 2022 to a current rate of about 3%. The chart below, published by the St. Louis Fed shows changes in the Fed Funds rate over th last 10 years.
While an increase in the Fed Funds rate typically brings inflation down, it causes the cost of short-term borrowing to go up. This is why we’ve seen increased interest rates on credit card debt, variable home mortgages, and other short term and variable rate loans.
Contrary to popular belief, long term mortgage rates are actually influenced by the rate of inflation more than changes in the Fed Funds rate. If inflation continues to decrease, we should see rates on 30-year fixed mortgages decrease as well.
What do we expect the Fed to do in coming months? The Fed has indicated that we might have another hike or two in our future, but as inflation approaches 2%, it’s likely they’ll at least pause their rate hikes.
What does this mean for you?
Now that we have a better understanding of inflation and Fed policy, what can we expect in the coming months and what implications does this have for our financial strategy?
While the rate of inflation has decreased substantially over the last year, predicting the future is complicated. With inflation still above the target 2%, the Fed will closely watch inflation, rate of economic growth, the unemployment rate and other factors as it makes its rate decisions at each meeting. Most likely, we haven’t seen the last rate increase, but hopefully, there won’t be many more.
As inflation comes down, we should see the 30-year mortgage rate decrease as well. This will provide an opportunity for recent home purchasers to refinance their mortgages at a lower rate. If mortgage rates come down, but the supply of homes remains tight, this could cause home prices to increase due to increased money available for housing payments combined with a low supply of homes for sale.
If the Federal Reserve at some point begins to decrease the Fed Funds rate, we’ll likely see rates on variable and short-term loans like home equity lines of credit, credit cards, and auto loans come down.
Now is a good time to take stock of your debt structure and borrowing needs and develop a plan to take advantage of possible decreased interest rates and lower inflation in the near future.