The Return of Inflation and Rising Interest Rates

For six years, from November 2008 to October 2014, the U.S. Federal Reserve pumped money into the economy through a program called quantitative easing (QE). They did this by creating money to buy mortgage backed securities (MBS) and Treasuries and adding them to their balance sheet. They increased their holdings by eight times for a total purchase of $3.7 trillion.

During the same time, the Fed lowered interest rates to zero, which is their normal tool for stimulating the economy. The main aim was to rescue the U.S. economy from deflation and the housing market from its freefall. Interest rates had never been that low in the history of our country.

Why the fear of deflation? Deflation occurred in the 1930s and contributed to the Great Depression. Deflation is defined as a decrease in the general level of prices in the economy, which means inflation has turned negative. This is a problem for economies because it can worsen a recession and it increases the real value of debt. When there are uncertain economic times, businesses and families hoard their money. Businesses in turn lower their prices to entice them to take the money and spend it. Then, the business and consumers see prices falling and wait to buy services or merchandise because it might be cheaper tomorrow. This is a deflationary spiral and can lead a recession into a depression. Deflation should not be confused with disinflation, which is the reduction in the rate of inflation.

Inflation is the rise in prices for goods and services and thus the worth of the currency is falling; inflation can also be described as the decline in purchasing power of a currency.  A ‘normal’ inflation rate is part of a healthy economy and the Federal Reserve has as one of its three goals, ‘stable prices.’ Stable prices are described as businesses being able to make long-term economic decisions and the Fed set an inflation target of 2 percent as the current normal level.

The danger in the Federal Reserve’s extreme accommodation of historically low interest rates along with huge amounts of money being flooded into the economy through the QE was the rise of hyperinflation. Hyperinflation is when an economy experiences very high and accelerating rates of inflation. In economic textbooks and in Zimbabwe, hyperinflation starts when a country’s government begins printing money and creating an oversupply. (At its height, Zimbabwe had a daily inflation rate of 98%, which means prices doubled every day). In retrospect, experts believe we avoided this disaster because the 2008 economy was in deflation and in such terrible shape. It is also surmised that the banks that were given the money didn’t lend as much as was anticipated because they needed to shore up their balance sheets with the surplus cash. The result is a change in the hyperinflationary causation to a complete breakdown of a country’s economy, which many countries try to counteract by printing money.

Currently, inflation has made a comeback. The consumer price index or CPI is the most common measure of inflation in the U.S. It is a measure of the change over time in the prices paid by consumers for a basket of consumer goods and services. In June, CPI hit 2.9 percent (on a 12-month basis) exceeding the Fed’s target and hitting a six-year high. Due to the robust economy and strong employment, Jerome Powell, the Fed Chair, reiterated the plan to continue to raise interest rates at a steady pace and two more are expected this year.

The increases are still small at .25 percent each time and interest rates are currently still at extreme lows of 1.25 – 2.00 percent. Wages are not moving up to reflect the stronger economy and full employment.  Average hourly gains only rose 2.7 percent year over year. At these levels, our earnings are not keeping place with the inflation rate so we are slowly losing buying power. Given the economy and employment numbers, expectations are that wages will need to be raised to stay competitive and keep and retain talent.

Even with the tariff battles, the U.S. economy and job numbers continue to improve and wage growth typically follows. Overall, we have come a long way from 2008 when financial systems were on the verge of collapse. Through interest rates and quantitative easing, the Fed avoided another depression and pulled us back toward growth faster than other countries. We found a way from deflation to a healthy, normal inflation rate.