Why the Fed Worries About Inflation

The Federal Reserve, like many government agencies and organizations, has a dual mission. On the one hand, it is the Fed’s job to keep the economy running smoothly and maintain the economic and monetary systems the country depends upon. On the other hand, it is the Fed’s job to prevent rampant inflation from crippling the economy. Doing one job well, sometimes means messing up the other job.

The-FedUnder normal circumstances, the Federal Reserve uses its power to set interest rates to moderate the ups and downs of the economy.

In a free market system, there are periods of expansion and contraction (good times and bad times). These variations in the economy occur for two main reasons. First, people (as a group), do not always behave rationally. Second, even when people are behaving rationally, there can be a significant lag between the arrival of data and the impact of that data on decisions.

For example, when we talked before about how inflation works, we talked about a man named Brad who, when prices rise, cuts back on spending by cancelling his gym membership. Theoretically, the exact moment for this to happen is when Brad’s expenses increase beyond his income. However, in real life, things are not so simple.

Is Brad’s spending power truly, and permanently, decreased by inflation, or are gas prices just a little higher this month because it is summer? Has Brad’s grocery bill grown to a new level, or did he just buy some extras this month because he had friends over. The variables are nearly infinite. At some point, Brad’s expenses increase to a point where the gym membership needs to be cancelled to maintain his financial situation, but exactly where and when that happens, can be difficult to see.

Now, imagine the flip side of this coin, where inflation forces several people to make similar decisions to Brad’s. Over the course of a few months, the gym notices that a rising number of people are cancelling memberships. Like Brad, there are many reasons this could be happening. If the gym decides that this is a permanent reduction in the number of members, it needs to make changes to stay profitable. It could, for example, lay off some staff members. On the other hand, it could try and appeal to more potential members by renovating or advertising more, or change its pricing. Just like Brad, when it becomes obvious that things have changed and that cutting expenses is the only real option, months may have already passed by.

Inflation versus Recession

In a perfect world, the effect of rising prices would cause a cutback in spending in proportion to the increase in prices at the same time the increase occurs. As we know, this isn’t what really happens. In fact, the opposite can happen because inflation is often misinterpreted in absence of other indicators.

Compare the scenario above to what happens in a recession. With pure inflation, prices are rising, but there are not significant layoffs or cutbacks on ordering, or the like. This allows both Brad and the gym to consider that there are other things going on in their economic situations. Brad rationalizes that he can’t afford as much because there have been “temporary” issues that have strained his cash flow. The gym rationalizes that membership sales are cyclical and they’ll pick backup in the fall, or after the New Year.

Without negative secondary factors coloring the viewpoints of people like Brad and the gym, it is easier to make decisions that do not involve reducing expenses. In a recession, Brad and the gym get other signals that the right move is to go defensive. There may be news stories about layoffs. Brad might know some friends that lost jobs. The gym might have seen a big business nearby close down, resulting in a nearly immediate reduction of memberships. When this happens, the gym won’t assume that it’s just a slow time of year. Instead, it immediately makes reductions in hours, cancels pay increases, and the like. Brad, cancels his gym membership right away.

Thus, the economic trappings of a recession, will automatically create a defensive posture in consumer and corporate spending. This is actually what causes a recession to deepen, but depending upon how the economy got there in the first place, the Fed can step in with rate cuts that can stimulate the economy and hopefully get it going again in a short period of time.

With inflation, the Fed has a trickier job. While rate cuts are simulative and popular, rate increases are not. Furthermore, inflation reports are just as confusing as Brad’s smaller situation. Are prices really rising, or was there just a seasonal blip?

When the Fed finally does decide to take action, inflation may have already been running higher than desired for several months, hidden by conflicting reports, or seasonal variations. Unfortunately, raising rates isn’t an instant brake. Rather, it can take several months for such action to work through the economy.

Consider Brad and his gym. Brad’s house and car payments won’t increase when rates go up. They are already set. Even a variable mortgage only resets once per year. That means it will be months before Brad notices that borrowing costs are higher. If the gym isn’t borrowing money, it won’t notice either, or it will be able to absorb the costs.

Once inflation takes hold, it can be hard to stop, and almost impossible to reverse. Even worse, the medicine for inflation (higher rates) can trigger a recession if the Fed goes too far and not only cuts back on over-spending, but normal spending as well. In a solid economy, Brad’s gym membership is a good thing, buying a higher-priced car than normal might not be. The Fed wants to put the brakes on one, not the other.

The Fed therefore focuses, some might say over-focuses, on preventing inflation from getting started at all. Those who are the most concerned about inflation are knows as “Hawks” and are favored by Wall Street, because they suffer the most when the value of money, itself, decreases. With each new report of good news, the Fed must weigh the question, “Is this news TOO good.”

Next up: Why better economic news can mean higher inflation.

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