When inflation rears its head, it makes its presence known in a very visible (and negative) way. Consumers are never excited to see prices of goods they purchase rise, but if their income rises faster than expenses, then who cares, right?
And that’s the crux of the problem. When inflation becomes high or unpredictable, and it doesn’t quickly dissipate, it can become self-sustaining as everyone tries to stay ahead of it. That is, until, like a fire, it gets smothered. So, when it does stick around for too long, businesses raise prices, workers expect higher wages, and thus it gains momentum.
And while the causes and effects of inflation are very clear, the cure can seem much less so. In three steps, here’s why the cure to inflation can be pretty painful, too.
Raising interest rates raises borrowing costs
The mechanism that the government uses to manipulate inflation levels is raising (and lowering) interest rates. When interest rates go down, it becomes less expensive to borrow, so businesses and consumers can spend more freely than they would have before (those who previously could spend do more, and some of those who could not, now can).
As we’ve previously discussed, reducing interest rates by 1.50% to scare off recession at the onset of Covid had a huge effect on what people could afford to spend on a house. If you had a $1M mortgage with a 4.5% rate, the monthly payment would be $5,066. With the rate reduced to 3.0%, $5,066 per month would get you a $1.2M house. When rates go up, this greatly reduces what that homebuyer could now afford.
Higher borrowing costs decreases business activity
In the first step, we talked about the effects on consumer loans, but how does this affect businesses? The effects are the same, but longer lasting, and so the effects on employment levels are greater. That’s because when a business borrows money it is usually spent on something used to grow the business over the long-term, so when used effectively it would lead to hiring workers over a similar time horizon.
But when businesses cut investment, it reduces employment opportunities. In its most severe form, a business may perform layoffs to avoid a financial calamity. Though, in a more normal scenario, businesses cut back on investment when anticipated growth and profitability goals don’t pan out, so they reduce hiring and investment before considering anything more drastic.
Less business activity leads to fewer jobs, less wage growth
In a white-hot job market (i.e. VERY low unemployment), businesses clamoring for growth raise wages hoping to outbid competing employers. Then, because labor costs have increased, businesses raise prices to cover their increased costs because they have to, otherwise profits may be wiped out.
Also consider that wages almost never go down, even during a recession. Why? Even when unemployment reaches extreme levels (i.e. 15%) the overwhelming majority of workers are still employed. And for the 85% who remain employed, they won’t change jobs so overall wages don’t go down, but wage growth (i.e. raises) will stall given the large number of unemployed job candidates.
Lower wage growth (and sometimes recession), is an ugly cure for inflation
So essentially, the key to taming inflation is reducing employment levels, because wage growth is very, very sticky. That is, until the job market changes and it has a reason not to stick around. No amount of job losses is pleasant, ever, and the higher inflation reaches the stronger the cure needed to stop it. And that’s why when inflation gets really bad, the cure, in its purest form, is recession.
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This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.