Understanding inflation and interest rates

This article will explain in easy to understand terms how recent inflation changes and interest rates are related, and the impact they have on the economy. It also explains why inflation and interest rates have been rising.

The Oxford English dictionary defines inflation as "a general increase in prices and fall in the purchasing value of money." It is a simple concept with far-reaching consequences for the economy. A discussion of the US economy needs to start with an understanding that the economy is global and impacted by actions and events around the world.  These events could be as distant as the invasion of Ukraine or as local as labor shortages in one’s current city.

The United States Federal Reserve has aimed to keep inflation to an average of 2%.  Keeping inflation low and stable provides consumers with predictable purchasing power and the expectation that they can make long-term purchasing decisions without fear that significant inflation will erode their purchasing power. Inflation dropped early in the COVID-19 pandemic but rose significantly in 2021 and 2022 (i.e., 4.70% in 2021 and 8.26% in 2022).  

Why is inflation rising?

The rising inflation has been caused by both supply and demand factors. To understand inflation, one must understand both kinds of factors. A June 21, 2022, Economic Letter from the Federal Reserve Bank of San Francisco estimated that more than half of the recent inflation has been due to supply-side factors, while demand-side factors have been the cause of about a third of the inflation. They were unable to pinpoint the cause of the remaining factors. 

During the height of the pandemic, manufacturing was disrupted in many industries by supply chain issues. These disruptions included pandemic-related quarantines that stopped the production of parts and finished goods. Labor shortages also caused other supply-side impacts with employees temporarily exiting the labor force or changing jobs. There was also a disruption in access to raw materials that negatively impacted manufacturing and supply chains. Raw materials like chemicals, metals, and agricultural products were constrained due to COVID-19 impacts on labor that affected the ability to mine, refine, and finish these materials. Distribution of goods was also impacted with fewer people driving trucks, trains, ships, and staffing ports. This caused delays in transporting parts and finished goods around the world.

With fewer products being manufactured and distributed; the scarce products that were available became more valuable. As their value increased, distributors and retailers could charge more, and prices increased (e.g., inflation.) The recent Fed letter highlighted several categories that have seen frequent supply-driven price changes recently, including “automobiles, fuel, and repair services.”

Supply chain challenges and related inflation worsened in 2022 with the Russian invasion of Ukraine. The war impacted fuel, food, and raw materials. According to the United Nations, “Russia and Ukraine provide 90 percent of the wheat supply in Armenia, Azerbaijan, Eritrea, Georgia, Mongolia, and Somalia. Ukraine is also a major source of wheat for the World Food Programme, which provides food assistance to 115.5 million people in more than 120 countries.” Russia and Ukraine provide nearly one-third of the world’s wheat, and barley, and more than 70 percent of the world’s sunflower oil. Russia also supplied many raw materials including aluminum, nickel, palladium, potash, vanadium, and copper. These raw materials are used to produce products exported around the globe.  The war in Ukraine has also caused severe disruption in the flow of energy throughout Europe both because of less capability to deliver due to pipelines flowing through Ukraine as well as embargos on products from Russia. Increasing the price of energy oil and natural gas has a cascading effect on many products throughout the economy because energy is used to produce almost every other product. “Russia is one of the world’s top three crude oil producers, as well as the second largest producer—and largest exporter—of natural gas.”

The result of the war in Ukraine is less food being delivered to countries across Africa and Europe, less raw materials available for the manufacturing of finished products, and less oil and natural gas being delivered to many countries. This all results in further reduction of product supply at a time when consumer demand is constant or increasing. The war in Ukraine made many raw materials, food, energy, and finished products scarcer and more valuable. In the same period, the demand for products has not gone down. This resulted in further increasing prices. (e.g., inflation)

One sector of the economy that has been a microcosm of the larger economy is home goods and home renovation. One of the side effects of the pandemic was that more consumers in the United States were spending more time at home. This caused more consumers to want to redecorate, remodel, and expand their homes. This led to an increase in demand for products like plywood, drywall, windows, doors, fixtures, and furniture. In the United States, this has resulted in a perfect storm of increased demand in many categories at the same time there is a reduced supply of products. When there is less supply and the demand is the same or greater, prices tend to go up. (e.g., inflation) Supply-side inflation has been elevated since the second quarter of 2021 and has increased recently. The recent Fed Letter also highlighted categories that have had frequent demand-driven price changes related to the pandemic, including “furniture, clothing, toys, video equipment, and cookware.”

The recent Fed Letter estimates that “Supply-driven inflation is currently contributing 2.5 percentage points (pp) more than its pre-pandemic average, while demand-driven inflation is currently contributing 1.4pp more. Thus, supply-driven inflation explains a little more than half of the 4.8pp gap between current levels of year-over-year Personal Consumption Expenditures (PCE) inflation and its pre-pandemic average level.”

Understanding Interest Rates

The Fed Funds Rate is an interest rate that the central bank uses to influence what banks charge to lend to each other. This affects the interest rate that banks charge consumers and businesses when they lend money. Increasing the Fed Funds Rate increases the cost of borrowing money, reduces the supply of credit, and makes loans more expensive. The U.S. prime rate is the rate charged by the 25 largest banks to lend money and is based partly on the Fed Funds Rate. The U.S. prime rate has increased from 3.25% in March 2020 to 6.25% in September 2022, with correlated increases in mortgage interest rates, credit card interest rates, and the cost of other lending. The question that is sometimes asked is “Why do central banks raise interest rates to solve the problem of inflation?”

In simple terms, if it costs consumers more in interest to borrow money, they are less likely to borrow, and less likely to spend. This reduces overall demand in the economy. To carry forward the earlier example, many home remodeling, home expansion, and home decorating projects may slow or stop. When there is less demand for the same available supply of products and materials, prices are likely to go down. In this way raising interest rates reduces demand and less demand tends to reduce prices.

As discussed earlier, inflation can be caused by both supply-side factors and demand-side factors. Central banks use interest rates to affect the demand-side of the inflation equation because it is difficult for them to address the supply-side factors (e.g. availability of products and labor).

The next question that one may ask is when will interest rates return to the relatively low levels that they were pre-pandemic? That question is difficult to answer because the interest rate increases only address the demand side of the inflation equation. They do not address the supply side of the inflation equation. 

There are several changes that are likely to be required to normalize the supply side of the inflation equation:

1. Availability of key raw materials and fuels like oil and natural gas (impacted by both the Ukraine war and some lingering pandemic constraints)
2. Manufacturers must be able to deliver relatively consistent levels of products to meet consumer and business demand
3. Sufficient labor must be available to produce and deliver products and services

Manufacturing supply chains have not normalized in many parts of the world and are unlikely to return to pre-pandemic normal for 12 to 18 months. China continues to periodically lockdown cities to address the pandemic, with an impact on manufacturing. 

In September 2022, after seven months of fighting, the war in Ukraine is expanding with 300,000 additional conscripted troops in Russia. This expansion of the war reduces the likelihood of a short-term end to the war in Ukraine. Due to the widespread destruction in Ukraine, it is unlikely that even, a quick end to the war would result in a normalization of the production and delivery of food, raw materials, and energy. In addition, the embargos are likely to be continued for products from Russia for an extended period.

The Federal Reserve in the United States may keep interest rates high for an extended period (e.g., years, not months) until supply-side factors stabilize. A recent survey of executives found that more than 50% did not expect supply chains to return to normal until the first half of 2024 or beyond. It is unlikely to be good for the economy for the Federal Reserve to see-saw interest rates up and down impacting demand without positive changes to the underlying supply side factors that are estimated to be more than 50% of the source of the inflation. 

Summary

When the supply of products and services goes down then prices tend to go up and when the supply goes up, then prices tend to go down. When consumer demand increases, then prices tend to go up. Raising interest rates is a way to make credit cost more for consumers and reduce consumer spending. This causes individuals to borrow less and spend less which reduces demand. When demand decreases, then prices tend to decrease.  In this way, raising interest rates reduces demand-side inflation.