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The Fed, Inflation, and Interest Rates

Dustin Holmberg shares his insight into how the Fed, inflation, and interest rates interact.

Fun fact for the day: According to the internet, the average age in the United States is 38.5 years old. Now, most of you under that age may have missed my subtle comment there in saying “according to the internet.” Those of you older than that also may have noticed that I violated one of the cardinal rules from our grade school days when I cited “the internet.” Why would I introduce a blog post about the Fed, inflation, and interest rates with idle chatter about the average age of a person in the United States and citing the internet? That’s a fair question, and one that I’ll dive into directly.

If half of the population is under the age of 40, then more than half of the population was either not alive or doesn’t remember the economy in 1980.  As a matter of fact, over the past 20 years (or the effective adult life of the average-aged individual), inflation has felt more like a relic from some old econ textbook, measuring over 3% only 4 times since 2000 and over 2.5% just 1 time in the previous decade. Science says that we are all subject to recency bias, and for better or worse, most of our adult lives have been spent under accommodative Fed rate policy. When news reports talk about the historical significance of the current inflation rates, the story sounds about as relatable as the stories of “walking uphill, both ways, to and from school in the snow.”

Enough of the confusion! Let’s start unraveling the inputs to see if we can achieve some clarity. Let’s begin with the definition of inflation. In plain terms, inflation is the measure of the change in cost of goods over time. More directly, a gallon of milk costs more today than it did yesterday, so we have inflation in the price. That’s an oversimplification and most economists are cringing right now, but it gives us a decent baseline.

Now let’s take that same definition of inflation and apply it more globally. Instead of relating inflation to a single thing, like that gallon of milk, we’re now applying this to the economy of “things.” So why would the economy of things cost more for me today than they did yesterday?

To answer this question, we turn to the concepts of supply and demand. There are too many dollars chasing too few goods in the economy today. When there’s more demand for goods than goods to sell, the competition over those limited goods increases, which raises prices. When you have sustained periods where demand exceeds supply (as we do in the current economy), inflation can become more persistent, causing prices to rise even further. So, the question becomes, is the ailment facing our economy a supply or demand issue? There are as many theories out there to answer that question as there are perceived “villains” to blame for the predicament we find ourselves in. Of greater importance to the topic at hand, however, is to understand the tools we have at our disposal to address both sides of the equation.
 

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Now that we’ve discussed inflation and supply and demand, we find ourselves ready to introduce the next player in our game, the Fed. The Fed is charged with maintaining price stability and stable employment. Inquiring minds may wonder why the Fed is so important to the discussion, and what tools they may have at their disposal to address the supply and demand imbalance.

The Fed cannot address the supply side of the equation. No single entity has the ability to solve all of the ailments on that side. Instead, the Fed’s tools have the power to influence the demand side of the equation. Remember that the Fed controls monetary policy. The Fed uses monetary policy to influence market interest rates. The Fed cannot fix the supply side, but anyone who has balanced a scale knows that balance is achieved by equaling the weights on either side. When the Fed raises interest rates, the borrowing cost rises, increasing the cost to acquire goods for market participants. The idea behind raising rates is to increase them to a point where demand decreases and comes in line with supply, achieving market equilibrium and stabilizing prices.

Throughout this article, I have attempted to steer clear of most of the noise that you typically find in the conversation about inflation and interest rates. Focusing on the noise often times brings emotions into the situation or calls us to come to some conclusion that frankly distracts from the point of the conversation. Our goal today was not to discuss the “whys,” but more to focus on the mechanics of the discussion to help you better understand what’s happening, and why certain actors are acting the way they are.

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