We’ve heard much speculation in recent months about whether the Federal Reserve (the Fed), the nation’s central bank, will begin to raise short-term interest rates. One measure the Fed is closely watching is inflation.
The inflation rate has not been a major concern in recent years. The annual increase in the cost of living has been below 2 percent the last two years, and was just 1.6 percent on an annualized basis in 2014*.
Many have been concerned that inflation is too low. With little change in the cost of living, there is less incentive for consumers to make purchases or for businesses to invest in new facilities or product development. Companies may have more difficulty growing profits, thereby hiring fewer people or limiting wage growth for employees. All of this can ultimately limit economic growth. A little bit of inflation is generally seen as a positive economic sign as it signals that demand is growing at a rate just slightly faster than that of overall supply.
The ‘inflation rate’ covers much ground
The most common inflation measure we hear reported in the media is the government’s Consumer Price Index (CPI). It measures the average change in the cost of prices paid by urban consumers for a market basket of goods and services. While your personal inflation rate will vary based on your actual purchase habits and the cost of living in your area may be different, the CPI helps us get a sense of how much living costs are changing on a broad scale.
An important fact to remember about the CPI is that some of the prices it measures can vary dramatically over a short period of time. A great example is transportation costs, most notably the price of gasoline. Over the past year, gas costs have dropped significantly, helping to keep a lid on the change in the overall cost of living. However, other elements that make up the CPI may be rising more quickly.
Because of short-term variations in particular segments of the economy, inflation is best viewed through a long-term lens. Even if costs in the near term are rising quickly, that doesn’t mean we’re headed for an extended period of higher inflation. On the other hand, lower inflation today may not be predictive of what will happen over the next few years.
The Fed’s challenge
Today, the Federal Reserve is still trying to take steps to keep inflation in check, but it’s also dealing with what has been an economy that is growing at a stubbornly slow rate. Many expect the Federal Reserve to raise short-term interest rates soon, partly due to the risk that excessively low rates could lead to higher inflation.
At the same time, the concern is that higher interest rates could slow the economy. In that event, the greater risk could be that the CPI actually turns negative, reflecting a decline in prices, or deflation. Sustained deflation can lead to a reduced standard of living for Americans, another outcome that policymakers are determined to avoid. The Fed also must consider that with prices for oil and other commodities so low, there may be more risk of those prices moving significantly higher in the future, which could spur another round of inflation.
Investors should keep a close eye on inflation news and how the Federal Reserve responds to it. If it appears that inflation could be moving higher, be prepared for the potential of the Fed raising interest rates more quickly. If inflation remains in check, the Fed may be in a position to proceed more cautiously with interest rate increases. Of course, inflation is not the only measure the Fed is watching. When exactly the Fed will raise interest rates remains to be seen. Seek out the guidance of a financial professional to learn more about how inflation, interest rates and other economic factors could impact your finances.
William “Drew” Watson CFP® is a Financial Advisor and Private Wealth Advisor with Ameriprise Financial Services, Inc. in Owensboro, KY. He specializes in fee-based financial planning and asset management strategies and has been in practice for 20 years. To contact us by phone, please call 270-684-8424, or mail to 111 West 3rd St, Owensboro, KY 42303. You may also visit our website at www.williamawatson.com.