Thanks to an agreed upon inflation rate among central banks in the U.S. and other developed nations, it’s been a while since the effects of rampant inflation were felt. A rate of 2 percent is believed to be sufficient to keep the economy steady: Growth without enormous price increases.1 However, inflation is a bit like the weather: We can attempt to predict it; we can prepare for it; but it is difficult to control.

Overview

The Federal Reserve Bank’s Federal Open Market Committee (FOMC) is the entity responsible for attempting to “control” inflation through monetary policy. The committee is guided by a Congressional mandate to promote maximum employment, price stability and moderate long-term interest rates. By focusing on these factors, the FOMC makes periodic adjustments to the federal funds rate — the interest rate that banks charge on funds loaned to each other overnight. A lower interest rate makes it cheaper to borrow money, which promotes business and consumer spending and therefore stimulates the economy. (1 )

However, more spending can lead to higher inflation. Companies use borrowed capital to expand their operations, which helps produce more jobs. More jobs means more competition to hire the best candidates, which means companies will pay more. Wage growth promotes more consumer spending, and so it goes.
Eventually, because companies are spending more money, they must raise prices. The cost of raw materials increases all the way down supply lines, so consumers end up paying more for goods and services. All of these factors cause inflation to rise.

When inflation rises, the FOMC contemplates raising the federal fund’s interest rate so it becomes more expensive to borrow money, and the whole economic process reverses itself.
Current State of Inflation

Despite the fact that the Fed kept interest rates at or near zero in the years following 2008, inflation has remained low. While the inflation rate posted modest but sustained growth in 2016, by the end of November, the personal consumption expenditure price index in the U.S. was up to 1.6 percent, still below the 2 percent target. The year’s progressive inflation rate was just over the 2 percent target. (2 )

In response to a significantly reduced unemployment rate and other signs of growth, the Fed raised the federal funds rate range to 0.50-0.75 in mid-December and projected three more possible rate increases in 2017. This forward guidance indicated the Fed’s confidence in positive growth prospects moving into the new year. (3)

In January, the Institute for Supply Management reported that its manufacturing index had reached a two-year high of 54.7, marked by the highest demand for new orders both domestic and abroad since 2009. Suppliers indicated that costs for raw materials have increased and price pressure is mounting for appliances, furniture and petroleum products. (4)
Inflation on the Horizon

If the economy experienced a moderate surge over the past year, that’s nothing compared to what’s expected to accompany the new presidential administration. With campaign promises for tax cuts and higher spending, some economists see “Trumpflation” on the near horizon. (5) New policies associated with the following objectives are expected to play a factor in higher inflation over the next few years:

Personal and corporate income tax cuts
More military spending
More infrastructure spending (e.g., transportation, clean water, a modern and reliable electricity grid, telecommunications, security)
Repatriated profits by U.S. companies
Greater capital spending for expansion and jobs
Less regulation
Global trade tariffs
Higher import costs for consumers and businesses
Tighter immigration standards

Economic growth and more jobs are likely to trigger wage inflation in industries ranging from technology to construction to agriculture. (6) Fortunately, proposed investments in infrastructure — expected to be a significant factor in increased jobs and spending — are supported by both Democrats and Republicans in Congress. This is one issue on which we could see significant movement early in the Trump administration.
Challenges

While the Federal Reserve only has so many instruments in the toolbox to help control inflation, there are other factors that will play a part. For example, America’s graying and retiring workforce could put a damper on productivity and new business formation. Technical skills training and retraining will be necessary to fill newly created jobs generated by the manufacturing, construction and technology industries.

The real estate market, the mainstay of President Trump’s business background, also could stagnate due to higher mortgage interest rates. And despite support for infrastructure projects, there will likely be opposition to increasing the federal government’s debt, already at record high levels — an issue that could see more resistance from Republicans than Democrats. (7)

At the end of the day, the executive and legislative branches of the government establish fiscal policy, while the Federal Reserve Bank is in charge of monetary policy. These entities work independently, as do a wide variety of market and economic factors. Thus, no one can actually control inflation. Analysts can attempt to predict it; businesses and consumers can prepare for it; but the most any entity can do is react with counter-measures once inflation takes off in one direction or the other.
Inflation’s Impact Over Time…

“At 2 percent annual inflation, a dollar loses half its value in about 36 years; at 4 percent inflation, it takes about 18 years.” (8)
Final Thoughts

Inflation affects people differently because of what each of us spend money on. For example, if you’ve been exposed to the cost of prescription drugs, health care services, health insurance premiums and college tuition over the past two decades, you’ve witnessed rampant inflation regardless of consumer price index numbers. For clients in or nearing retirement, it’s important to consider how inflation may impact personal expenses and plan for them accordingly.