For many years now, the Federal Open Market Committee (FOMC) has stated publicly that they want to “target” a 2% rate of inflation1. Here, we will discuss why they might have such an aim as well as where we stand in relation to that stated goal.
Before we begin, let us define inflation. The Merriam-Webster dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services”. Simply put, inflation is the rise in the cost of goods and services.
Prices rise due to supply and demand. To illustrate using a simple example let us think about this in terms of auto fuel.
The chart below shows the average gas prices by month. The summer months typically see an increase in gas consumption as these are the months Americans traditionally take vacations, many by automobile. So as the demand for fuel rises, so does the cost since the supply is relatively stable.
Chart Source: U.S. Energy Information Administration
One of the reasons we typically see only a modest rise in fuel prices during the typical summer is because the above-mentioned trend is well known. As a result, crude oil refiners anticipate the increased demand by increasing their output thereby minimizing the increase in price. Because this pattern is largely predictable, the oil refineries can anticipate and build their production schedule accordingly.
But what happens when the demand for something rises faster than the suppliers can plan to accommodate that increased demand? It becomes a bidding war. If this occurs on a single item, it is not a significant problem. Sometimes this happens at Christmas with the year’s surprise “hot” toy. While we might see angry parents who struggle to obtain “the” toy at a reasonable price, the situation is limited to a small segment of the economy.
The greater problem arises when we see this throughout the economy. If the demand, across a wide cross-section of goods and services, rises at a rate faster than the supply we will see inflation throughout the economy.
But this is not altogether bad, for if an economy is not experiencing some degree of inflation, it implies the economy is not growing. Therefore, inflation is a signal of a growing economy.
This is exactly why the Federal Reserve attempts to “target” an inflation rate of ~2%. They believe that a 2% inflation target is the level of a healthy, growing economy but one that is not growing too quickly which would result in an overheated economy and one headed for a recession.
Where are we today?
The chart below is from the St. Louis Federal Reserve website and the Federal Reserve Economic Database (FRED). The third paragraph of the disclosure on the St. Louis FRED website below this chart states the following, “The CPI can be used to recognize periods of inflation and deflation. Significant increases in the CPI within a short time frame might indicate a period of inflation, and significant decreases in CPI within a short time frame might indicate a period of deflation.”
An examination of the chart clearly shows that we are experiencing “significant increases” in prices. Recognizing that the gray bars on the chart are recessionary periods, one can also see that these recessions occurred after a period of rising inflation.
Chart Source: St. Louis Federal Reserve
The above chart includes “all items” and it is generally not the CPI data with which you may be familiar. When the general media refers to inflation, they are generally referring to the chart at the end of this article which excludes food and energy. Since most of us use both food and energy, we like to look at the chart above. However, for those who may want to reference the more traditional CPI without food and energy, you will find that below. A close examination of that chart will also show a rising trend.
What we might expect: rising prices.
The budgetary implication: for the average American, this means that you might want to consider reviewing your budget to make sure you are prepared for this anticipated increase in your day-to-day living expenses.
The investment implication: we must remember that a key reason why anyone invests is to outpace inflation. Therefore, if inflation is rising, it might mean your portfolio will have a harder time maintaining that original objective especially if you are “conservative”.
For us, at Hicks & Associates Wealth Management, we have and will continue to make the adjustments that we believe are most appropriate. Naturally, if you have any questions, please do not hesitate to reach out to us. We would be happy to review your portfolio for you.
Chart Source: St. Louis Federal Reserve
References & Footnotes:
1 – If you would like to read more about the FOMC’s 2% inflation target, check out their article entitled “Why does the Federal Reserve aim for inflation of 2 percent over the longer run?”