One of the surprises of the current economic cycle that began in early 2009 has been the lack of inflation. Economists worry about inflation levels because it erodes consumers’ purchasing power. Economic theory has long believed that as unemployment falls, inflation rises. With fewer people looking for jobs, wages tend to rise as companies look to retain employees or lure employees from lower-paying firms. Expecting this trend, the Federal Reserve has been raising interest rates, one of the main tools it uses to slow economic activity and restrict inflation. However, even at today’s very low unemployment rates, inflation rates remain below average. This is largely due to the combination of productivity gains from new technology and the globalization of the labor force, both of which limit wage growth.
With continued low inflation, the Federal Reserve is now hinting at lowering interest rates. Lower rates should help sustain our economic growth by discouraging saving and encouraging borrowing and spending. Lower interest rates also should give a short-term boost to equity and bond prices. However, historically the Federal Reserve has only lowered rates when the economy has begun to weaken and nearing a recession. Investors will be watching the Federal Reserve very closely over the next few months for any signs of economic weakness.
Alan Bergin is the Senior Vice President of Fund Evaluation Group in Dallas, TX, the Foundation’s consulting firm. Financial Forecast is a quarterly installment produced by FEG and the Community Foundation.