Inflation – What is it and How Long Will it Remain?

Inflation is the nasty word we’ve been hearing a lot about this year. Inflation is defined as the increase in prices and decline in the purchasing power of money. Inflation generally runs about 2% per year in this country and, until recently, the United States has not experienced severe inflation for almost 40 years. Lately, consumer price index inflation has been in the 8-9% range, which is severe and can have catastrophically negative effects on purchasing power, especially when wages do not keep up (and for the people who are most impacted, they haven’t).

There are various reasons why inflation has run so hot lately. One is that the government pumped a lot of money into the economy in the form of stimulus and bond buying to keep interest rates low during the pandemic. While this was important to stabilize the economy and provide support for people impacted by and not being able to work during the pandemic, there are consequences to all this new money. Another reason is that supply chains were interrupted due to Covid lockdown measures or reduction in employees. Another reason, which is important but not pandemic related, is the war between Russia and Ukraine, which is reducing the worldwide supply of oil as well as other resources, which inflates prices.

Housing has been another driver of inflation as supply has not been able to keep up with demand for purchases or rentals. If housing formations increase faster than construction of new dwellings, demand exceeds supply and prices go up. Additionally, construction costs go up as wages and costs of materials and land increase making new homes more expensive.

Clearly these situations have created an affordability problem for many people. One thing that can be done about it is our central banking system raising interest rates in an effort to slow the economy. Since March, the Federal Reserve, who sets short-term interest rates has raised the funds rate from just above 0% to above 3%. They have signaled they will increase this rate at least another percent by early next year and the stock market has shown that the do not like this. Stock prices have dropped by more than 20% (some much more than this) and bond yields have more than doubled since the beginning of the year. In times of high inflation, more bonds are sold than are purchased, causing prices to go down and yields to go up. Bond yields have the most direct effect on mortgage rates, so this has also caused interest rates to more than double, which weakens housing. The belief of many is that the FED should have started raising interest rates earlier as the economy had been overheating for about 6 months before they did anything about it.  

So what’s next? The fed meets again in early November to announce the next rate decision. Between now and then the monthly inflation data for September will be released. The current year over year inflation rate for August is 8.3%. This is a 12 month rolling average, so each month of this year, the previous year’s month drops off and that monthly value is replaced by the current value. Last September, the CPI rate increased .4% on a monthly basis. This might be replaced by a lower value, lowering the yearly rate, although the overall inflation rate will still be close to 8% and this will cause the FED to increase rates again, slowing the economy once more. In October, November, and December of 2021, CPI inflation grew at a rate of .9%, .7%, and .6% respectively, so I expect large decreases in the annual inflation rate as we move forward and probably close to 2% again by April 2023 as we replace the ugly high early 2022 numbers with smaller ones.

Bottom line is because the FED waited too long to start this process, they missed their chance for a “soft landing” and are raising rates too late. By the time they get to their target in the 4% range, this will be too much since inflation will already be under control and will push us into a recession (or a worse one than might have been). A rate increase that is too large along with quantitative tightening (selling bonds and reducing the money supply) will lead to bond yields falling and probably a good refinance opportunity as rate drops follow bonds.