What is inflation? What causes inflation? And why do we invest in the stock market (hint hint: to outpace inflation). Inflation was 8.9% in the summer of 2022, and even though it's currently around 3.7% as of September 2023, we are still feeling the lag effects. The memes talking about the struggles a lot of us are facing are plentiful! There's definitely a trickle effect happening
Inflation is a concept that can seem complex, but at its core, it's about the purchasing power of money and how it changes over time. Let's break down this economic phenomenon in a straightforward way.
Inflation refers to the gradual increase in the prices of goods and services, which, in turn, reduces the purchasing power of your money. A little bit of inflation, around 2%, is generally considered healthy for an economy because it signifies slow and sustainable growth. Central banks, like the Federal Reserve in the United States, often target a 2% annual increase in inflation to maintain stability.
Imagine you're back in school, and your teacher wants to explain inflation to you using an interactive activity. Essentially, if you want to know how to explain inflation to a child. Here's how it would go:
Now, students can finally open the bags, only to find that they contain identical items. What's happening here is a simplified representation of how inflation works in the real world.
The person handing out money in this activity represents the Fed or other economic factors injecting more money into the system. As students receive more money, they are willing to pay more for the same bag of items, which mirrors the diminishing purchasing power of their money. In the real world, this is akin to too many dollars chasing too few goods, leading to inflation.
this is why you invest in the stock market. If you have cash sitting there, it loses its purchasing power over time because 2% inflation year over year is actually good for the economy. So you invest in the stock market to outpace inflation, which historically it has
Inflation can be caused by changes in supply and demand for products/services and money itself. Here are a few theories:
Inflation is monitored using metrics like the Consumer Price Index (CPI), Producer Price Index (PPI), and Personal Consumption Expenditures (PCE). To control inflation, central banks adjust interest rates. Higher rates reduce spending, which can help combat inflation, but they also risk causing economic downturns.
The recent surge in inflation can be attributed to a combination of factors that shook the global economy. Here's a closer look at the key events that contributed to the inflation situation:
The COVID-19 pandemic, which began in early 2020, prompted widespread lockdowns and supply chain disruptions. Factory closures, bottlenecks at ports, and restrictions on international trade all played a role in disrupting global supply chains. At the same time, governments worldwide issued stimulus checks and increased unemployment benefits to support individuals and small businesses impacted by the pandemic. Additionally, central banks, including the Federal Reserve, lowered interest rates to near-zero levels to stimulate economic activity. This massive influx of money into the system was intended to prevent a financial collapse during the pandemic.
With the sudden increase in disposable income due to government stimulus and low-interest rates, consumers went on a spending spree. This surge in consumer spending, coupled with trends like the skincare craze and increased investments, led to a heightened demand for goods. Notably, the technology sector experienced a significant boom.
The pandemic also prompted a shift in housing trends, as more people sought larger homes or moved to different areas. This resulted in a housing boom, driving up real estate prices and rents significantly.
In early 2022, Russia's unprovoked invasion of Ukraine triggered a series of economic sanctions and trade restrictions on Russia. Since Russia is a major producer of fossil fuels, these actions limited the global supply of oil and gas. Additionally, Ukraine's large grain harvests couldn't be exported due to the conflict, leading to higher food prices. Rising fuel and food prices then rippled through various value chains, contributing to inflationary pressures.
As the COVID-19 pandemic receded, consumers started to embrace travel and services again. This resurgence in demand for airline tickets, hotels, and other services led to an increase in prices, particularly in the travel sector.
The Federal Reserve has been closely monitoring the inflation situation and implementing policy changes in response. Here's a snapshot of the Fed's current stance:
Federal Reserve Chair Jerome Powell and the Federal Open Market Committee (FOMC) have taken a cautious approach to address inflation. They have opted for a "hawkish pause" as of September 2023 moving away from aggressively raising interest rates. Here are some key points from the Fed's recent actions and statements:
Restrictive Interest Rate Increases: The Fed has raised interest rates to 5.25% over the course of a year. However, these policy changes take time to filter through the economy, a phenomenon known as a "lag effect." Consumers are still spending as credit card limits haven't been reached, and rent prices are slow to adjust because longer-term leases need time to expire and rollover.
Focus on Core Inflation: The Fed pays attention to core inflation, which excludes volatile elements like energy prices. Recent data suggests that while new lease rates are still 20% higher than pre-pandemic levels, they have come down from the extreme increases observed in 2021.
Data-Dependent Approach: The Fed emphasizes its reliance on data when making policy decisions. Powell and the FOMC remain cautious and flexible, considering the uncertainty of economic factors and the lag effects of previous policies.
In summary, the Fed is in a delicate position, carefully adjusting interest rates to control inflation while avoiding a rapid economic downturn. They are closely monitoring economic indicators, such as labor market conditions and consumer spending, to determine the appropriate path forward in their pursuit of price stability and a strong economy. It seems that Fed has reached the end of their hiking cycle and will look to find the sweet spots where rates will remain. (The higher for longer narrative).
Inflation is a crucial economic concept that impacts our daily lives. Understanding its causes, measurement, and control is essential for making informed financial decisions. As we navigate these economic dynamics, we'll continue to see how the central banks' actions influence our purchasing power, investments, and overall financial well-being.
Jessie: You know, Jess, I've been seeing a lot of memes and posts from friends about inflation for a while now. And there's, you know, things like this is a wage shortage, not a labor shortage.
Jess: Ooh, I've seen those too. Or the comparisons about how it was so easy to buy a house 20 years ago on a similar lower salary. Things were just different. Things our parents did.
Jessie: Right. How much easier it was back then. And the prices of groceries and rent still feel so high.
Jess: All right. So it sounds like we should talk about the inflation situation.
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