An Economic Game of Chicken: Covid vs. the Fed vs. Inflation

You may remember hearing horror stories, a decade or so ago, about how poor monetary policy in Zimbabwe sent prices for consumer goods skyrocketing to absurd levels. For example, at one point the price of a loaf of bread exceeded $500 million (yes, really). Granted, those are Zimbabwean dollars – but it’s still just as bad as it sounds. 

That is one very dramatic example of how much influence governments can exert over their nations’ economies. Right now, as lockdown measures lift and economic recovery ramps up, the threat of excessive inflation is on many people’s minds. And the government’s response to it – specifically that of the Federal Reserve (or just “the Fed”) – has come under scrutiny. 

So let’s dig into this with some specific questions. What causes inflation in the first place? How is it the Fed’s problem? Why are people worried about the Fed’s response to it? And, perhaps most importantly – should you be worried? 

Covid and the causes of inflation

Although it’s seldom as dramatic as the Zimbabwe example, inflation is an inevitable economic phenomenon. At the turn of the 20th century, a nickel could buy you a whole afternoon’s outing; now it can buy you… not much of anything. 

This upward creep in prices is obvious over the course of a hundred years – but it’s also measurable from one year to the next. Sometimes the inflation rate is a trickle (2% growth in a year), sometimes it’s a stream (7%), and in really crazy cases like Zimbabwe it’s a dam-busting flood (500%). 

The reasons for inflation are still debated to an extent, largely because we only have about 120 years of accurate data on it. Most economists agree on a few broad causes however:

  • Higher demand – Obviously, when demand increases for goods and services, their prices go up as well. This type of inflation is in overdrive at the moment: as lockdown measures expire, people are buying stuff, eating out, and traveling again after over a year of not doing so. Demand is way up for all sorts of things, and prices with it.

  • Higher production costs – If businesses encounter new expenses in providing their goods and services, they’ll raise prices to make up the difference. This is also in overdrive right now: a host of recent setbacks have increased production costs across multiple industries. Some of these setbacks are themselves due to the pandemic... but a freakishly large number are just coincidences. 

  • Greater cash supply – When a product or resource becomes more abundant, its value drops – and this is just as true for dollar bills as for any commodity. Whether citizens are liquidating their long-term assets or the government is handing out stimulus checks, an increase in readily available money (known as “M2” in finance shorthand) lowers the buying power of money overall. In other words, stuff gets more expensive.

  • Built-in inflation – The other types can and often do spin off into this type over time. Employees demand higher wages to keep up with the rising cost of living, and then businesses raise their prices so they can afford to pay those higher wages, and around and around it goes. This type of inflation is usually creeping in the background, even when the others aren’t prevalent. 

To give you an idea of how dramatic the situation is currently, below is an illustration of the recent spike in cash supply as a result of stimulus payments. After eight years of steady but gradual increase, the M2 supply rocketed upward in 2020 and has kept accelerating since then:

It’s too early to tell whether built-in inflation will increase as a result of this spike (and the similar ones in overall consumer demand and production costs). But it’s a definite possibility. And the Fed stands as one of our main lines of defense against that possibility. 

The Fed to the rescue – maybe

The stated objective of the Federal Reserve is, quite simply, to help the economy run smoothly. More specifically, it tries to keep prices from rising or falling too fast – no $500 million loaves of bread, please and thank you. 

And as the nation’s central bank, it has some impressive tools that it can use to accomplish this. One of its most significant powers is that of setting short-term interest rates. Lower rates encourage more borrowing and spending, which speeds up the movement of money throughout the economy; conversely, higher interest rates encourage saving, which slows things down.  

A growing economy – like today’s – is obviously a good thing, but an “overheating” one is problematic. When inflation is running high, money is moving rapidly and unemployment rates are unsustainably low, then it could mean a bubble is about to pop. The dot-com bubble in the early 2000’s and the housing crash in 2007 were both the result of growth moving too quickly.

In such situations, the Fed may need to put a damper on things via higher interest rates. It’s like when your big sister made you turn down the music in your dad’s car; yes, she was a buzzkill, but a boring ride is way better than blowing out your dad’s speakers and getting grounded. 

So… are we currently at risk of blowing out the speakers? Or is all the “heat” right now just a healthy, natural rebound after the long winter of 2020? For the moment, the Fed has basically opted to wait and see

On the one hand, Fed officials don’t want to throttle the much-needed recovery that’s happening right now unless they really have to. On the other hand, there’s no denying that inflation is moving faster than they initially expected – it’s currently riding at about 5%, while the sweet spot is considered to be 2%.

But in addition to controlling prices, the Fed’s other big mandate is to keep the employment rate up. That objective has its own set of unique challenges right now, and tightening things up too soon with higher interest rates could theoretically make it worse. So the Fed expects to keep interest rates near zero until 2023.

Should we be worried?

Not surprisingly, everyone’s got an opinion about how the Fed should proceed. Some are glad they’re still keeping interest rates down, because that basically means the party can continue. Products are flying off the shelves, prices are rising, the stock market is bumping and – arguably – more people are getting a piece of the pie than ever before. Who wants Mom and Dad to come home and shut that down?

On the other hand, many are worried that the Fed’s hesitancy to raise interest rates will give this otherwise-temporary spike the opportunity to grow into a mountain. Remember the phenomenon of built-in inflation: although inflation is often triggered by external causes, it can also spiral into a vicious, self-fulfilling cycle. If that happens, we’re in trouble.

So now, the moment you’ve all been waiting for: should we be worried? 

In short… yes. 

Wait, I mean no! 

I mean... sort of. 

Put it this way. We’re already experiencing high inflation; and in my opinion, it’s very likely to keep getting higher and/or last longer unless the Fed pivots dramatically from their current course of action. But while it’s tempting to view that as purely bad news, it’s not really so simple.

What you can do about inflation

Without getting into the weeds of why it happens, I can tell you right now that inflation is generally good news if you’re invested in stocks, real estate or “hard assets” – raw commodities like precious metals, oil or lumber. It can also be great for borrowing: when inflation is rising but interest is still low, as it is now, then you’re effectively getting a discount on any fixed-interest loans you take out.

On the flip side, of course, inflation isn’t great for lenders – it drives down the value of the interest they receive back. But the ones who really feel the brunt of it are the wide swath of the population that doesn’t invest; the ones who live more or less paycheck-to-paycheck. If inflation accelerates enough, their cost of living rises faster than their wages and they literally get poorer. 

In short, inflation is good news for investors and borrowers; on the other hand, it’s bad news for consumers and lenders. Individuals can stand to benefit even when it’s running “too hot;” but in the long term, excessive inflation widens the wealth gap and that, in turn, leads to a wide array of other problems. 

Since you yourself have no control over what either the Fed or the economy will do (hate to break it to you), the question in the end is this: how can you exploit the benefits of inflation while avoiding the dangers as much as possible? 

In short, it’s a great time to invest in stocks or real estate and – perhaps counterintuitively – a great time for debt financing. If you’ve been waiting for the right opportunity to venture into either of those, and have the resources to spare, then I can tell you fairly confidently that now is that opportunity. 

It’s also a rather unprecedented one. Today’s perfect storm of pent-up demand, flooding cash and supply chain disruptions is so singularly weird that there’s no telling what effects it will have in the long run, and it likely won’t repeat anytime soon. You can take that as either a warning or an encouragement, depending on your perspective.

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