May 9, 2024

Understanding Inflation and Interest Rates: Insights with Current Context

5-minute read
What Drives Inflation? Exploring Economic Factors, the Interplay with Interest Rates, and Effects on the Stock Market

According to a 2022 survey by the American Psychology Association, a significant 83% of adults indicated that inflation has become a notable cause of stress. In a landscape where media headlines are crafted to capture immediate attention, the broader public frequently finds itself grappling with heightened levels of anxiety. These headlines, often devoid of the necessary context, contribute to a sense of unease. While we can't influence your local grocery store to lower egg prices or negotiate a salary increase on your behalf, we are dedicated to offering financial education that assists you in navigating these intricate economic dynamics.

Let's begin with the fundamentals...

Inflation refers to the pace at which prices of goods and services escalate. The Consumer Price Index (CPI) is the common measurement for this, tracking the monthly shifts in prices paid by consumers across various categories like housing, apparel, transportation, food and beverages, and medical care. Inflation is an inherent aspect of any economy; in fact, the Federal Reserve aims to maintain inflation at approximately 2.0%. However, the issue arises when the inflation rate starts to increase disproportionately and at a faster pace than wage growth.

There are two main categories of causes for inflation:

1. Cost-push inflation: This occurs when the expenses associated with producing and delivering services rise, and these increased costs are subsequently transferred to consumers.

2. Demand-pull inflation: This situation arises when the demand for goods and services surpasses the available supply and/or production capacity.

The U.S. experienced both of these inflation causes in recent years.

Following the Covid-19 pandemic, a chain reaction of events was set into motion...

  • Massive labor market tightening (job vacancies), giving employees major leverage to demand higher pay.
  • Factories shut down across the globe in efforts to stop the spread of the virus causing a huge supply/demand imbalance.
  • The Russian/Ukraine war vastly reduced the supply of global grain. 
  • Amid the COVID-19 pandemic, there was a substantial decline in oil demand due to reduced activities such as driving, boating, and flying. However, even as consumer behavior gradually returned to its usual patterns after the pandemic, oil production did not rebound to its pre-COVID levels.
  • Interest rates remained at historic lows meaning companies and individuals could borrow money affordably and manage higher mortgages and loan balances. 

Savings accounts built up as people spent less during the Covid lockdown while employment numbers stayed strong. So, once the world opened back up, people had a lot more play cash to spend and an itch to travel.

Recall that the target inflation rate is 2.0%... In 2019, inflation was at a manageable 2.3%[1]. In 2020, Covid-19 pandemic’s onset, inflation dropped to 1.4%, but then spiked to 7% in 2021[1] inflation high that the US had not seen since the 80’s. And by summer of 2022, inflation peaked at 9.1% [2].

Introducing the intervention of the US Federal Reserve, also known as the Feds:

Their role involves overseeing the money supply within the US economy and maintaining a balance in inflation, employment, and economic growth. The mechanisms they employ to achieve these objectives fall under the category of Monetary Policy. The approach they adopt in adjusting these mechanisms hinges on the prevailing state of the economy:

a)  Contractionary - control inflation; slow down rapid growth.

  • Action: Raise interest rates > borrowing is more expensive > people spend less > companies need to cut costs to stay profitable > unemployment rises > demand lowers > inflation lowers

b)  Expansionary - stimulate growth in the economy.

  • Action: Lower interest rates > borrowing is cheaper > more people are employed > people and companies spend more > demand for goods and services increase

Since March of 2022, we’ve been in a contractionary monetary policy environment.

This approach was adopted not only due to rising inflation concerns but also to enhance preparedness for a future economic downturn. With interest rates hovering close to zero, it became necessary to establish a margin for reducing rates during future recessions. The Federal Reserve (Feds) executed rapid and frequent hikes in interest rates with a purposeful approach.

This explains the stock market's decline in early 2022, not because the economy had weakened, but due to investors' response to the Feds' announcement of aggressive interest rate increments aimed at curbing inflation.

This move served as an indicator to investors that an impending recession might be on the horizon. This is significant because in an environment of increasing interest rates (characteristic of contractionary monetary policy), consumers experience reduced disposable income, and companies encounter greater challenges in sustaining profitability. This impact is particularly pronounced for growth-oriented businesses with substantial debt (think tech stock companies). When coupled with economic experts foreseeing a minimal possibility of a "soft landing" (resolving inflation without slipping into a recession), it's understandable why a substantial shift of investment flows occurred from the stock market and into cash, culminating in a -18%[3] year-end return for 2022. 

Therefore, although there isn't a direct causal link between interest rates and the stock market, the extent of its impact on investors' outlook for the future and the subsequent measures they adopt becomes evident.

Fast forward to this blog post, August 2023 - the stock market has recovered its 2022 loss.

What we are seeing is that inflation is coming down and our economy is still doing well. Interestingly, some of the economic experts who initially projected a 0% probability of a smooth transition have now altered their forecasts, expressing newfound confidence that we could potentially rectify inflation without triggering a recession. Regrettably, for those who withdrew or scaled back their stock investments during the 2022 downturn, the rebound was missed.

The main takeaway here is that it pays to stay the course and not make big investment decisions out of fear. 

Unfortunately, no one can perfectly time the market on a repeatable basis. Even with the best AI and algorithm tools. This is because the market's movements are influenced by human emotions and inherent biases. The substantial historical evidence indicates that investors reap rewards in the long run when they concentrate on controllable factors: maintaining a diversified investment portfolio and holding sufficient cash reserves to navigate bear markets, thereby allowing investments the time needed for recovery. This approach helps avoid the expensive error of having to liquidate assets at market lows to raise cash, potentially missing out on subsequent market rebounds. The assurance of having ample reserves of cash hinges on effective and continuous financial planning.

Ironically enough, inflation is actually fundamental to why we invest - to protect purchasing power over the long-term as life gets more expensive.

Because inflation is a natural economic phenomenon, cash loses its buying power over time. The key is to align your investments with your tailored financial plan so that when we experience inevitable periods of market volatility, you can be confident in staying the course. 

Understanding these complexities can be overwhelming, and that’s why we’re here to help. Download the Pattern iOS or Android app to connect with a Pattern advisor today.



[3] S&P 500 index total return

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