This is a video version of a post I wrote recently. Click the video player below to watch the video.
In recent months there has been fears of inflation, and one reason is that during the COVID-19 pandemic the U.S. government printed trillions of dollars to counter the economic impact and print stimulus checks. According to some reports, about 20% of all U.S. dollars were printed during the pandemic in the form of stimulus checks.
What is the Federal Reserve (aka The Fed)?
According to Wikipedia, 3 key objectives of the Federal Reserve are: 1) maximizing employment, 2) stabilizing prices, and 3) moderating long-term interest rates. When inflation is looming, one way to combat inflation is to increase interest rates. However, increasing interest rates usually has a negative impact on the stock market and bond markets. This is because many companies borrow money in order to run their businesses. When the cost of borrowing (i.e. interest rates) increases, this means companies’ earnings will be lower.
The Fed injects $120 billion monthly to bail out the stock market
When the COVID-19 pandemic hit in March 2020, the stock market tanked. In order to save the stock market, the Fed injected $120 billion per month buying bonds and securities. This was funded by printing extra money and therefore causing inflation to increase.
Why does printing extra money cause inflation?
Inflation means it costs more money to purchase goods and services than it did in the past. It means your dollars are losing purchasing power. For example, in 1970 it costs 25 cents to buy a cup of coffee. In 2019 it costs $1.60 for the same cup of coffee. When there is more money in circulation, the cost of goods and services increases.
You may be wondering why this happens. For example, if you had $100 and I had $100, you may be willing to pay $1 for a cup of coffee. But if both you and I had $200 each, because we have more money, we are willing to pay more for the same cup of coffee because we have more money to spend. This is an oversimplification, but it is an illustration of why prices of goods and services increase when there is more money available.
What’s next?
An inflation of 2-3% per year is normal, but sometimes inflation goes out of hand for example in 1974 the inflation rate was 11% during the stock market crash of 1973-1974. When inflation goes out of control, the Fed may choose to increase interest rates which discourages consumer spending. However, increasing interest rates can have a negative impact on the economy and stock market.
Whether the Fed increases interest rates and how often they choose to raise interest rates remains to be seen.
Calvin K. Lee Author 