We know that inflation is currently at a 40-year high. And we know that is not a good thing. But do we know why? And how does that affect interest rates? Or us as business owners?
Inflation is technically defined as “the decline of purchasing power.” What does this mean? It’s about supply and demand. If you have one of something, it will be worth much more than if you have a million of those same things. And if you have fifty million, then the price goes way down because they are readily available. There will be no bidding war. So with all the funding put into our economy over the last two and a half years (PPP, ERTC, stimulus payments, etc) in order to avoid a large recession, that obviously increased the monetary supply of the US dollar, thus becoming less valuable, thus taking more dollars to buy the same amount of things.
Inflation reached a 40-year high of 9.1% this summer. So, what does an interest rate of 9.1% mean? It means if something costs $100 right now, that same product a year from now will cost $109.10. Because this same dollar is going to become less valuable, and it will take 9.1% more currency to buy this same thing. The currency you currently have is becoming devalued, so you need to have more of it to buy the same products.
Interest rates are considered the Federal Reserve’s biggest tool for combatting inflation. The Federal Reserve is a government organization that’s behind the scenes controlling our whole banking industry and lending. They meet at least 8 times per year to set the standard interest rate for banks’ lending money, which can speed up or slow down the economy. When inflation is too high, the Federal Reserve will typically raise interest rates to help slow the economy and bring inflation down. When inflation becomes too low, the Federal Reserve lowers interest rates to stimulate the economy and help move inflation higher. Right now, they are continuing to raise interest rates in order to stifle purchasing, which will in turn slow demand. This means prices go down and inflation goes down.
Housing and home-related costs are the majority affected by interest rates, because they are usually people’s biggest expenses. (Think mortgage, rent, utilities, etc.) However, there are a lot of other things affected as well such as food, airline travel, and fuel costs. There is a silver lining to high interest rates though: savings account interest rates are also higher when inflation is high – Now is the time to save! The biggest piece of advice we can give you right now on the personal side is to save your money. We recommend against aggressively paying down low interest rate mortgages/debt. Why? If your current mortgage is 3%, then paying that down will give you a 3% return on investment (ROI). So, if you pay an additional $100 on your mortgage, you are getting $3 back. Conversely, putting that same $100 into a CD at 5%, that will be $105 next year. This is a great incentive to take your money and invest/save where interest rates are high. Plus, this helps you have liquid cash, as opposed to equity in case something major comes up. Remember, cash is king and if we’ve learned anything from the past 2 ½ years, it’s how important it is to have cash reserves.
Now for a piece of professional advice: Usually the inflation rate hovers around 2.5%-3% each year, which is why we normally tell our shop owner clients they need to raise labor rates at least 3% every year just to keep up with inflation and break even. Now we are telling clients to raise their rate by 8-9% to keep up with inflation. Yes, that is a huge jump, but if you increase a little each month, or even each quarter, it won’t be such a huge shock to your system or the clients’.
These rates will not continue to be this high for a long time, at least that’s what history tells us. It’s hard to say what it will look like in the future.
Hunt has recently done some podcasts on this topic. Check out the following episodes for great supplemental info!
https://paarmelis.com/business-by-the-numbers/
Episode 23: Inflation – What You Need to Know
Episode 24: Interest Rates
Episode 25: Inflation Reduction Act – What We Know
Episode 30: Driving Profits Through Labor
