Good Economic News and Inflation

It seems any time economic news gets reported, there is a good news / bad news sort of thing going on. If there is an economic report that offers up good news about the economy, that is paired with the bad news that the Federal Reserve is either not going to do anything (recently) or may move to increase interest rates. Either way, that seems to worry some people, no matter how good the economic news might seem other wise.

The Fed and Inflation

Federal Reserve Inflation graphicThe Federal Reserve’s mission is to regulate the U.S. economy independently of the U.S government. That role has never been as important as it has been lately when Congress and the President seem constantly paralyzed by politics from taking any steps or implementing any policy to help the economy. In particular, the Fed’s role is to help regulate U.S. monetary policy. This is a historical mandate, and it shows that those who created the Federal Reserve had remarkable foresight, because what is good for the country’s economy does not often square up with what is good for the political parties that want so desperately what to gain and hold power.

There are two main missions for the Federal Reserve. The Fed’s job is to keep the economy running smoothly (read: growing) and to control inflation (read: not growing too fast). Unfortunately, these missions are not always aligned with each other.

The one specific issue that falls completely under the power of the Federal Reserve is controlling inflation. This is primarily because the actions by which inflation can be controlled are never politically popular, no matter how necessary.

The Fed’s chief weapon against inflation is the ability to set interest rates. Specifically, the Federal Reserve sets two interest rates. One is the Discount Rate, which is the interest rate that the Fed charges banks to borrow money overnight. This rate is actually seldom used in practice, because banks typically borrow in this manner from other banks, who are less nosey. However, it does set a floor for overnight lending between financial institutions, because who would want to pay 3.5 percent from a bank, when the Fed will do the same for 3.0 percent, no matter how nose they might be?

The Federal Funds rate is also set by the Fed. Getting this interest rate to stay near the announced target is the job of the Fed Open Market Committee.

What Is Inflation and How Does Inflation Effect the Economy?

Inflation is a simple term for complex process. Inflation occurs when prices rise, or more accurately, when the purchasing power of money falls. However, price fluctuations happen everyday. Furthermore, the prices of some things rise while others fall. Inflation, in a nutshell, is when enough prices on enough things rise far enough to reduce the purchasing power of a fixed amount of money.

In English, it goes something like this:

Brad earns $25 an hour and works 40 hours per week. That means he makes $1,000 a week, or $4,000 per month.

(For our purposes we’ll ignore taxes. It really doesn’t matter if Brad earns $4,000 before or after taxes, the effect of inflation on his spending is the same.)

If Brad has a $2,000 mortgage and fixed expenses of $1,000, then he has $1,000 of discretionary income each month for things like gas, eating out, buying stuff and going places. Brad, like most people, buys approximately the same amount of goods and services each month when averaged out over time. However, if prices rise, then Brad cannot buy the things he is used to buying.

If Brad can’t buy the things he usually buys, then he has to cut back. Let’s say he cancels his gym membership. If enough people do the same thing, then this cuts into the profits of the gym. Eventually the gym, itself, cuts back by firing people or putting off new purchases, which in turn causes other people and businesses to cut back.

Under ideal circumstances, this effect slows down the overall economy to a more sustainable pace. However, the world is not ideal. Instead, Brad and others may take on more debt, especially if it is cheap. (Remember when a new 0 percent credit card offer showed up in your mailbox every week?)

Eventually, Brad not only has too high of expenses, he has too high of debt. When this occurs on a large enough scale, the economy doesn’t slow down gently, it comes to a screeching halt.

Economic cycles are natural. There are expansions and contractions (growth and recession). When the economy decelerates quickly, this is called a hard landing, and it can not only be very devastating, it can take years to recover from.

Next Up: Why does the Fed care so much about inflation?

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