Why inflation happens — and the role of the Fed

Labor shortages raise costs of doing business and get passed on to consumers

The post-lockdown rebound of the economy sent employers scrambling for workers — while an increasing number of workers were choosing to drop out of the labor market completely. This and other post-lockdown factors have led to a persistent labor shortage in many industries.

Employers have responded by raising wages, which means they ultimately need to raise prices to keep pace.

Rising energy and transportation prices raise the cost of many things

When energy prices rise, it's not just the rising cost of gas for car or home heating oil that goes up.

Food prices started surging during pandemic lockdowns when many families started stockpiling nonperishables and buying more food at the grocery store (instead of eating out). But food prices continued to rise even when consumers slowed or stopped panic buying. One reason for this increase? Rising energy prices raising the cost of growing, producing, and transporting food.

The trucking industry has experienced ongoing difficulties getting products from ports or warehouses to sellers due to rising gas prices and record labor shortages. This raises the cost of transportation for many products, including household furnishings and construction supplies.

In addition, the war in Ukraine shocked the food, natural gas, and crude oil markets driving these commodities' prices up even higher in recent months. That will ultimately impact the cost of many goods, especially those that require energy inputs to manufacture or transport.

Pandemic trends exacerbate existing housing shortage

The pandemic triggered record numbers of people in the U.S. to move. Part of this was due to many workers being allowed to work remotely, freeing them from high-priced employment centers like the Bay Area or New York City. Part of this was due to mobile workers seeking warmer climates where they could take advantage of outdoor activities during pandemic restrictions. And part of this was due a more mobile workforce seeking places with lower taxes, open schools, and fewer pandemic restrictions.

In addition, many people who were cooped up at home and working from home were seeking more space — extra rooms for a home office, yards, or simply fewer roommates.

All of these pandemic trends exacerbated an already tight housing market. This caused housing costs, especially rents, to jump substantially, too. This was especially true in the Southeast, which saw a huge influx of new residents during the pandemic.

The Fed increases interest rates to slow inflation

Whenever inflation exceeds the Fed's prescribed of rate of a 2% annually,3 their policymakers feel compelled to use monetary policy to bring it down. While the Fed doesn't directly control interest rates, raising the federal funds rate typically causes lenders, who now pay higher rates for borrowing money, to raise interest rates on borrowers.

That's because banks loan money to one another out of surpluses in their reserve accounts held at the Fed. When the Fed raises its rates, the federal funds rates — the interest rate banks pay to borrow money from other banks — goes up, too. To make up for this cost, the banks raise the interest rates on consumer loans.

The Fed continues to raise interest rates incrementally to bring down inflation, which is why you're seeing multiple interest rate increases by the Fed. When the cost of borrowing money increases, consumers spend more of their money on interest for their loans, mortgages, and credit cards. This typically causes people to spend less, which causes demand for goods and services to fall, which creates a downward pressure on prices.

In addition, these consumer cutbacks in spending lead to revenue losses for businesses. Less revenue may cause some business to cut operating costs by reducing payroll and other costs, leading to layoffs, which further dampens consumer demand. But changes in consumer habits aren't the only reason businesses are impacted by higher interest rates. As cost of borrowing money goes up for business borrowers, they may halt expansion plans, including hiring new staff.

The combination of layoffs and hiring freezes may cause consumers to become nervous and begin scaling back spending because of job loss fears. That leads to revenue losses for businesses, meaning more layoffs and hiring freezes.

All of this brings prices down, reducing inflationary pressures on the economy. But it may also have an adverse effect on your finances. If you're concerned about how inflation is impacting your portfolio, reach out to your Synovus financial advisor to learn more about how to weather the current bout of inflation.