There are few topics which come up in casual conversation these days more frequently than inflation. It’s been discussed at cocktail parties, business meetings, and around the dinner table for more than two years. After decades of seemingly endless low inflation, it returned during the Covid pandemic in a big way. But it’s heading back down again.
Last month’s data showed inflation was at 5% for the previous 12 months, a continued decline from the month before. That doesn’t tell the whole story. Most of the inflation of the past year happened last summer when gasoline prices spiked. Over the last six months, the average annualized rate of inflation was closer to 2%. While you may have noticed increases at the pump in the last few months (gas is up about 30 cents per gallon now over last December), it’s still down $1.50 since last June.
And the inflation rate hovering at or below 5% for the next 6 months or so makes sense, as the risk-free rate of return (what a safe investment like a 6-month Treasury Bill is now paying) is about 5% as well. Those numbers usually work in tandem. Compare this to a year ago, when 6-month T Bills were paying 1.3%, but inflation was surging. Back then, many experts thought inflation would be short-lived and we would return to “normal” soon, so investors weren’t yet demanding higher rates for their cash.
Supply shock vs. demand shock
Inflation had been low for so long, why would anyone think this case was different? Most recessions are caused by a shock in demand. Consumers and businesses are concerned about the future, so they reduce their spending. They delay big purchases or new hiring, and a recession is caused by the rapid drop in the demand for goods and services. But this downturn was caused by a supply shock too.
The most famous supply shocks came in the 1970s with the oil crises. When gasoline was hard to come by, goods weren’t moving around the country. People and business stopped buying not because money was tight, but because there was less available to buy! Supply shocks generally lead to recessions because spending drops and the economy contracts. That happened at the beginning of the pandemic. We all remember the difficulty in buying goods at the grocery store, finding new or used cars to purchase, and the constant refrain about how “your order has been delayed because of supply-chain issues.” That was our supply shock, and it’s stayed with us for the past two years.
What does all this mean for the future and for all of our finances? The Federal Reserve has been raising interest rates, but have they raised them enough to combat inflation? While no one knows the answer to this, I expect interest rates will likely continue to rise a bit.
Interest rates have increased more in the last year than at any time since 1981. They can easily go higher, but this supply shock was different from the last one, when rates skyrocketed. Interest rates hit a high of 15.2% in 1981, but we won’t come close to that even though the Covid shutdown in 2020 was more of a global problem than even the oil shocks were in the 1970s.
It’s important to note that moderately higher interest rates offer benefits as well as concerns. If you have credit card debt or a variable rate mortgage, you may be paying more. On the other hand, higher interest rates also mean better returns in low- and no-risk investments which incentivizes people to save more. Historically, these higher savings rates have led to future investment both by individuals and corporations. If it’s similar this time, it should translate into long-term economic growth.
We expect the Fed will continue to raise rates slightly in the short term. In the longer term, China is reopening its economy at the end of their zero-Covid policy. As their supply issues resolve, we may even see inflation fall below current interest rates, which could lead us into rare territory: money in the bank could start giving a real rate of return. If inflation is 3.5% and your bank is paying you 4.5%, you’re actually making a small profit just by leaving money in the bank. That hasn’t been the case in decades.
Rest assured, all of us at Gottfried and Somberg are watching these numbers carefully. We’re always here to discuss this topic or any other concerns you might have.