Inflation has been a headline story throughout much of 2022, and the latest readings show that it doesn’t seem to be going away anytime soon.

Many were hoping that inflation—which can be simply defined as a general increase in the price of goods and services in an economy—would soon reverse as economic activity returns to normal. But the consumer price index (CPI), which tracks the price of a basket of common goods and services, posted its biggest increase in 41 years in May. Energy prices were up a sobering 34.6%, and food prices rose 10.1%.[1]

Consumers probably weren’t surprised by these numbers—they have been feeling the effects of inflation in their wallets for a while now. Meanwhile, the U.S. Federal Reserve (the Fed), whose mandate includes keeping the price level stable, has been forced to take stronger action. The Fed announced a 0.75% increase in the Federal funds (Fed funds) rate—its biggest increase in 25 years. The Fed also signaled further increases to interest rates ahead.

Inflation and interest rates—joined at the hip

Inflation and interest rates are closely intertwined. When interest rates are low, it becomes cheaper for both businesses and consumers to borrow, whether that is through credit cards, auto loans, or a home mortgage. Cheaper credit drives demand in the economy, which places upward pressure on prices. High interest rates should have the opposite effect—limiting borrowing activity among consumers and businesses and eventually driving down economic activity and the price level.

But interest rates aren’t the only factors involved in this chain of events. Other important variables that affect inflation include:

• Increase in the money supply. Inflation is sometimes referred to as a monetary phenomenon. When the money supply grows faster than the economy, too much money chases too few goods and services, and prices rise. The Fed flooded the economy with stimulus money during the pandemic. Money supply rose to $22 trillion in April 2022 from $16 trillion at the start of 2020.[2] This extra cash eventually drove the price level higher.
• Economic crowd behavior. Disruptions in economic supply, including for example the supply of available workers in the economy, can spark wage-price spirals as businesses raise prices to stay ahead and protect profits. If businesses think high inflation is temporary, they may hold back from increasing prices. But once the belief spreads that inflation will persist, the cycle can become self-reinforcing.

The Fed’s blunt tools

The Fed doesn’t control inflation directly. Instead, it has two blunt tools at its disposal:

• Federal funds rate. The Fed funds rate is the rate at which the Fed lends to banks. Banks then lend to each other at rates that are based off of this benchmark rate. The banks use funds from the Fed as reserves to create loans to businesses and consumers. When the Fed funds rate rises, borrowing costs increase economy-wide.
• Buying and selling securities. The Fed maintains a balance sheet of assets, mainly Treasury bonds and mortgage-backed securities. When the Fed buys assets, it injects liquidity directly into the banking system, and the money supply expands. When it sells assets, the money supply contracts. During the pandemic, the Fed went on an asset-buying spree, known as quantitative easing (QE), to support the economy. Its balance sheet ballooned from $4 trillion at the start of 2020 to almost $9 trillion today. Now, as part of its fight against inflation, the Fed is winding down its balance sheet, a process known as quantitative tightening.[3]

You may add a third blunt tool to the Fed’s toolkit—psychology. Through its words and actions, the Fed can affect market behavior. The Fed’s latest moves signal its determination to break inflation. This should have an effect on all economic actors and may help to break the cycle of inflationary behavior.

Fallout from the inflation fight

Examples of how the Fed’s aggressive focus on inflation is affecting the economy include:

• The 30-year fixed mortgage rate is close to 6%, up from around 3% just last year, which means the monthly dollar cost of owning a home has doubled.[4] This has cooled a hot housing market and cut demand for building supplies, roofers, plumbers, and others in the residential housing supply chain.
• The prime rate has risen to 4.75% from 3.25% a year ago. Borrowing is more costly for corporations, which usually leads to a slowdown in hiring.
• Credit card borrowing rates are rising. The average annual percentage rate is now close to 17% versus 16% or less at the start of the year.[5]
• The S&P 500 Index has fallen more than 20% year-to-date. Markets hate uncertainty, and this market has plenty. For example, investors don’t know how high inflation will go, how long it will take the Fed to tame it, and whether interest rate rises will trigger recession.
• So far, the U.S. unemployment rate remains very low, but there is anecdotal evidence of increasing layoffs and hiring freezes.

The odds of a recession

The Fed has a dual mandate—to pursue both price stability and maximum employment. The two objectives can be at odds, because raising interest rates to contain inflation can push the economy into a recession.

This increases the potential for “stagflation”—a combination of slow growth and persistent inflation. Most commentators don’t expect a repeat of the stagflation the U.S. economy experienced during the 1970s. So far, consumer spending has held up, although it has shifted from spending on goods to spending on services like travel and entertainment. Many economists think the remaining cash from covid stimulus packages and higher savings rates among consumers will continue to support the economy and encourage growth.

But warning signs are visible. For example, the bellwether University of Michigan consumer sentiment index fell to an all-time low of 50.2 in June [6], and retail sales were down month-on-month in May for the first time this year.[7] Personal consumption expenditure is the largest component of GDP. If it weakens, a recession becomes more likely. All eyes will be on the U.S. consumer to see what happens next.

Leelyn Smith will continue to closely monitor inflation and interest rates in the coming months. If you would like to learn more about how this evolving situation affects your financial plan, please don’t hesitate to reach out to your Leelyn Smith advisor.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

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[1] US Bureau of Labor Statistics, Consumer Price Index Summary

[2] St Louis Federal Reserve, M2

[3] US Federal Reserve, “Recent Balance Sheet Trends”

[4] Freddie Mac, Mortgage Rates

[5] Creditcards.com, “Average credit card interest rates: Week of June 15, 2022”

[6] Business Insider, “Americans have never felt this bad about the economy”, June 10, 2022,

[7] CNBC, “Retail sales posted unexpected 0.3% decline in May as inflation hammers consumers”, June 15, 2022