The economic outlook for 2022 looked very promising for the world. After two years of pandemic the world needed some normality. However, two situations have put in suspense that normality so expected by everything. Inflation and russia’s invasion of Ukraine have put the economy on edge. Today we will see how inflation is affecting the world economy and how the Increase in interest rates of the Fed seeks to mitigate it in 2022.
Global inflation had already become a problem. Most countries provided subsidies to families and businesses to operate safely during the pandemic. For people, it guaranteed support in the face of illnesses and the possibility of becoming unemployed due to the restrictions of the covid19 pandemic. For companies, this meant that they were supported to minimize the dismissal of workers and thus avoid further unemployment.
But that subsidy money didn’t come from increases in the economy’s productivity. On the contrary, the money from the subsidies came from the inorganic issuance of money. The inorganic issuance of money is a way for states to generate more circulating. The problem is that money without support in the economy or productivity usually ends up causing inflation. Next, we will analyze how inorganic money generates an increase in inflation.
Inorganic money and inflation, the effect of subsidies
That’s because you have the same amount of goods and services, but more money with which to buy those goods. It’s like having a cake for 12 people and inviting 14 people, in which case the following can happen:
- Let them fight over the cake.
- That the birthday boy decides to divide the pieces into smaller pieces.
- It may happen that the birthday boy gives cake only to those who brought gifts. Or if all the guests brought gifts choose to give cake only to those who brought the best gifts.
The truth is that “invitations” or “money” begins a progressive process of loss of value. This translates into:
- In the first phase there is a shortage of goods and services. There is more money, but the goods are the same, so they run out.
- Merchants can raise prices so that the products do not run out quickly or so that those who really need it buy it.
- Finally, other people who need these products see that prices are rising and begin to increase them.
If the problem of scarcity is not dealt with by producing more or with prices, other pernicious effects are generated:
- Shortages may increase further due to the lack of measures.
- Processes of hoarding and diversion of merchandise from the usual marketing channels may occur.
- Distribution can occur through influence peddling, causing corruption in both the public and private sectors.
Prices are the most efficient form of wealth distribution
Prices are the market’s way of fixing the value of goods. It marks the balance between what a person is willing to pay with respect to their actual utility. We do not refer to pricing by the seller. More than one will have witnessed how a product when it rises a lot in price stays on the shelves.
The actual price is the price at which the product is traded. A price set on a product that is not sold is a farce. On the contrary, if that price is fixed in such a way that the transaction occurs naturally, it is because that price is convenient for both the buyer and the marketing chain.
In this way inflation reflects the loss of value of money. If the underlying situation is punctual, controls can be carried out to try to mitigate the effects of a non-structural shortage. This should be done for a short time, with the risk of increasing scarcity by reducing incentives to improve distribution or production.
By increasing the amount of money and keeping the same products, shoppers will “compete” for the products available. In this way buyers will enter into a kind of “auction” of available products and services. This is what produces inflation. Those who cannot, or do not want, to obtain their product at the auction will have to satisfy their need in other ways.
This happens when the potato is missing, and people replace it with sweet potato or another vegetable. The price at which goods and services are traded are a way to know the value of things for everyone. Inflation is the loss of the value of money with respect to products and services.
The Russian invasion of Ukraine and its effect on inflation
Another element that has pushed inflation is the Russian invasion of Ukraine. This invasion has triggered alerts on Russia’s warlike behavior, prompting the imposition of sanctions against the energy giant. These sanctions seek to prevent money and investments from the United States and European countries from financing the war against Ukraine.
U.S. and European sanctions against Russia are causing the following effects:
- Shortage in the supply of oil and petroleum derivatives.
- Problems with gas supply for Europe.
- Shortage of wheat, corn, and barley.
These products represent important exports for Russia, and a source of financing for the war. But Russia is an important source of oil, gas, and wheat supply for the world, and especially for Europe.
The price of avoiding a war is to temporarily take on a problem of scarcity and price increases because of the sanctions needed to stop it. This effect is in addition to the effect generated by the issuance of inorganic money.
Russia was probably counting on inflation in Western economies to be an obstacle to the imposition of economic sanctions. However, Western nations considered the political-military risk to be greater than the economic risk. In the end, political-military risk can also become an economic risk, if it translates into invasions, wars, and destruction.
With this outlook driving inflation, we wonder how interest rates can help control inflation. Next, we will talk about how the mechanisms to stop inflation employed by the US Federal Reserve work.
Interest rates, inflation, and the Fed
The interest rates of the Federal Reserve System of the United States are one of the mechanisms that the Federal Reserve must control inflation. But let’s review a little bit what the Federal Reserve is and what tools they must act on inflation.
The Federal Reserve is fundamentally the Central Bank of the United States. It is a public-private entity. On the one hand, representing the public sector is the Board of Governors of the Federal Reserve System. On the private side are the 12 Federal Reserve banks.
The Board of Governors is an independent public institution. Their decisions are subject to the Freedom of Information Act but cannot be approved by the president or Congress.
Board of Governors of the Federal Reserve System makes decisions whose purpose is to focus monetary policy to keep inflation at bay. Another of its objectives is to maximize employment in the country. It is why they intervene currently where the United States has record inflation, the highest in 40 years.
While rising interest rates help lower inflation, it can affect economic growth, and with-it employment. That is why managing economic policy from the Fed means finding the balance between inflation, growth, and employment.
Now the challenge is to get what will be the equilibrium point for the Fed between inflation and employment.
Fed interest rates and inflation
Now the Fed raises the interest rate by 0.25% and is expected to continue raising it. Analysts assume that the next two increases will be 0.5%. This means that debts will increase your interest rates and make money more expensive.
It will also start selling U.S. debt papers. This means that it seeks to contract the working capital while increasing the cost of borrowing. This policy decreases liquidity and will make it more costly to borrow, probably diminishing growth prospects.
Commodities are also rising in price. The U.S. economy is expected to contract. This will lead to falling prices on the stock market and to the slow growth of companies.
These measures could also affect the real estate market. However, it is expected that thanks to the aid packages and the end of the coronavirus it will be well prepared. The U.S. economy is ready for the plan of measures against inflation, and we expect to see a strengthening of the currency and with it a decrease in inflation.
Failure to achieve a decline in inflation risks weakening the dollar. This would weaken its international hegemony and its value as a global transaction currency could disappear.
That is why it is key to achieve a consensus to address the inflationary issue from an integral perspective. Interest rates affect the value of money or “debt,” but it’s not the only factor we need to consider. That is why we will move on to what are the elements that produce inflation.
Basic elements that produce inflation
Inflation is a complex phenomenon. The elements that can drive inflation are varied, and these elements are interconnected. Below, we’ll point out the basic elements that drive inflation and its relationships:
1- Increase in prices of basic supplies.
There are supplies that are basic for the industry because of their broad impact. Earlier we mentioned oil, necessary to produce fuel, plastics, lubricants, and fertilizers.
There are also other supplies that can greatly impact prices. One of them is the fertilizers or components that are used for its manufacture. This component affects food production and food prices.
Energy and water are usually other supplies that if their price is affected affect prices throughout the supply chain.
If we consider that labor is a “supply” of the productive chain, raising wages without considering productivity can induce inflation.
Controlling and moderating the increase in basic supplies can be one of the keys to controlling inflation.
2- Excessive increase in liquidity due to monetary issue
Let’s see why “unbacked” monetary issue causes inflation:
- Issue of money generates an increase in the demand for goods and services. People who have more money consume more.
- Part of these supplies for production can be obtained in the local market, but others will have to be imported.
- Additionally, there are finished products that are not produced in the country and will have to be imported.
- The government should have international reserves to meet the increased demand for raw materials and imported products.
- This money can go to acquire finished products, semi-finished or raw materials that will meet the growth of demand due to money issued.
- There must be a ratio between the growth of liquidity and that of international reserves.
Depending on the type of economy of a country, the ratio of reserves or liquidity will be higher or lower. The more outputs and inputs produced domestically; the fewer international reserves will be needed. However, there are no self-sufficient countries.
If there are not enough reserves to import, or if production is not able to respond to demand, an “auction” situation is generated between available goods and services and consumers.
This auction effect is the cause of inflation, which always appears when supply is insufficient to meet demand. That is why stimulating demand can be inflationary, if there is no response capacity of the country’s productive, importing, and financial apparatus.
As we see the issue of inflation is complex. We have addressed 2 of the elements that produce inflation, but they are not the only ones as we will see below.
The recommendations before the increase of the Interest Rates of the FED.
Gustavo Mirabal Castro bets on prudence in the face of investment scenarios due to the likely slowdown in the US economy. The Fed’s rising interest rates and the Fed’s sale of sovereign debt will have multiple impacts.
It is important to study well the financial instruments in which you want to invest. This will allow you to evaluate the real value of the investments and decide if it is the right time to invest.
We must wait for the shares to be as close to their real value as possible before proceeding to act. Otherwise, we could be facing a scenario of purchase and decline in value. This scenario would lengthen the process of recovering our investment and seeing the benefits.
Therefore, before buying, you should be advised expertly. If you, do it that way you will have your investment insured. Do not look for friends or gurus to advise yourself financially. Look for real experts to get your money in good hands. Those are the advice of Gustavo Mirabal Castro, especially in times of so much uncertainty.