Inflation and Your Investments
Inflation has been a topic that seems to be on everyone’s minds. We wanted to take some time to give our clients an overview on what causes inflation and just what the Fed’s role is in combatting inflation.
What Causes Inflation
This is actually pretty simple. When governments spend more than they take in there is a deficit. This causes governments to borrow to make up for that difference. Essentially the government is adding more currency to make up for what was spent but not on hand. This excess currency then trickles thru the economy eventually leading to overall higher prices.
Something to keep in mind is inflation is not necessarily a bad thing as long as it is kept in relative check. The Fed’s official mandate is 2% per year. This is what they see as being healthy for an economy. Essentially slow growth without slamming the brakes on spending. However when government spending increases suddenly without an increase in revenue the Fed is often forced to act to keep prices from skyrocketing.
Fed’s Role
The Fed has significant oversight in what is called the federal funds rate. The federal funds rate is the overnight rate banks are charged to borrow from one another. When the Fed meets and wants to raise or lower rates this is the rate they are targeting.
By raising or lowering this rate the Fed forces banks to act. When the rate is lowered banks enact a lower interest rate which encourages more borrowing and thus more spending. However when the rate is raised borrowing becomes more expensive and thus spending generally decreases.
From 2022 thru 2023 the Fed had been aggressively raising this target rate. This then made the cost of borrowing much more expensive and encouraged less spending. Spending less means lower demand for goods and services. When demand decreases then prices begin to stabilize because consumers are spending less. This is why the rate of inflation fell as the Fed aggressively moved to raise rates.
Can the Fed Cause Prices to Decrease
This is a question that came up frequently as inflation began to surge in 2022 and continue thru 2023. While it seems like it would be great if prices could go back to 2019 levels this is one of those situations of having to be aware of being careful what we wish for.
Deflation, when prices decrease suddenly, is often caused by an overreach in policy and has unintended consequences. Economies are often sent reeling backwards as spending declines and causes for widespread cuts to employment. This in turn causes continues downward pressure as less people working mean less people spending. The Great Depression is unfortunately a case study in what happens when a deflationary cycle begins and is something the Fed is very cognizant of avoiding repeating at all costs.
Current Status of Inflation
As stated earlier the Fed’s mandate is 2% inflation per year. Right now the Fed is inching very close to realizing that goal and as such has begun to slowly decrease interest rates. The goal here being to thread the needle of reducing the rate of price increases while not stalling out the economy.
How This Affects Your Investments
Positioning your portfolio so inflation does not take away from future spending power is very important. A less aggressive approach can sometimes preserve the value on paper but may actually lose in the wrong run depending on how inflationary pressures shake out. As always we are happy to conduct a full review of your investment portfolio and assist in tailoring a strategy to help keep your future spending power in tact.