Inflation, Interest Rates, and the Market

Marshall W. Gifford |

by Marshall W. Gifford


I wanted to take some time and break down a couple of the current economic and geopolitical trends, from my perspective. The topic in the headlines most consistently lately has been regarding inflation and interest rates. First, I am going to address the fundamental issues causing inflation. If you break inflation down to its root cause, it is too much money chasing too little goods. When the money supply is increased, like the federal reserve did during Covid, there needs to be a corresponding increase in the size of the economy to absorb those dollars. However, the money supply increased at a greater rate than the economy.

During the shutdowns many people continued to earn incomes, but were unable to spend them on travel, dining, or events. They chose instead to spend money on decks, second homes, pools, patios, cabinets, boats, cars, and TVs. People focused on things that would allow them to enjoy their time at home or with family more since they couldn’t spend money on leisure, dining, and travel. This means more money started flowing into areas such as lumber, computer chips, countertops, windows, etc. at a time when there weren’t enough workers to accommodate the increased demand. This “shortage” bid up the price of normally easy to obtain items.

Demand inflation is easy to understand in a simple analogy. Let’s assume you just finished a road race and crossed the finish line. At the end, there is a table covered in water bottles for you to freely take. You enjoy the water but would not be willing to pay $10 for it since it is plentiful. Let’s put that same water bottle in the middle of the desert with you dying of thirst. You come across a small market with one bottle of water left. How much would you pay for that bottle? Now $10 might seem like a bargain. It is the same item, but depending on the level of demand for it, the price can change dramatically. The demand for specific items and the lack of workers to produce those items coupled with the general increase in money supply is why we are seeing inflation at 40-year highs.

The solution being proposed is to raise interest rates. How does this help with inflation? By raising rates, banks will essentially pay people to keep money in savings and that should slow the flow of funds out of accounts. When interest rates are 0%, there is no opportunity cost to spending money in the bank. If rates are 4%, every $10,000 you spend from your bank now has a $400 annual opportunity cost. (Had you left it in the bank you would have earned $400 in interest.) In addition, on large purchases, people typically borrow money. If you finance an item at 0% interest, you are more likely to borrow money than you would at 5% interest. A car loan for $50,000 at 5% interest over seven years costs $703 per month, while at 0% interest it costs $595 per month. Raising rates can slow spending, thereby reducing the dollars that are bidding to purchase the same item. The hope is that with Covid restrictions easing and workers going back to work, the supply of goods can be increased. Also, with rising interest rates the demand for those goods will hopefully be decreased.

In addition, long-term historical trends would not indicate runaway inflation long term. One area of life that we take for granted is technology, and technology is a major deflationary force. In the 19th century, 50% of the labor force worked on farms. Due to modern farm equipment, fertilizers, and higher yields per acre, today it is closer to 2% of the labor force.1 Then jobs switched to manufacturing and technological efficiency changed those, as well. With the introduction of automation and robotics, the need for as many human workers was eliminated. Broadly speaking, the trend has been for technology to replace manual jobs which decreases the amount being spent on wages. With fewer wages there is less money for consumption, reducing demand and reducing prices. If you think about the cost of items we use every day, from microwaves that can be purchased for $59 to flat panel TVs for $199 that used to cost $2000, Moore’s Law continues its progression in which the number of transistors on a microchip doubles every two years and the cost of computers drops in half. So, while inflation is a problem now, long-term forces should work to counterbalance the current circumstances over time.

Another question I get quite a bit is, “Has the stock market held up during inflationary times and rising interest rates or should I just leave my money in the bank?”. If we first look at cash in a bank currently earning 0% interest, if inflation is 7% this year, your real return on that is -7%, so cash is not a great option for long-term funds. Think of your last trip to the grocery store, or Target, or the gas station. Did you pay more or less than a year ago? Do you think you’ll pay less next year? When you checked out, you generated revenue for those corporations. The price of the higher cost goods was passed on to you. If everything is 7% more, a business with pricing power can raise prices and generate 7% more revenue on the same number of items sold. With the higher revenue, profits should also be higher allowing the stock to hopefully generate a return equal to inflation, thus maintaining your purchasing power. Historically, stocks have been a very good inflation hedge.

Regarding the geopolitical landscape, specifically the war in Ukraine and China’s Zero-Covid policy, both of these are creating issues with energy supplies and supply chain disruptions. Putin’s aggression is sickening, and Russia will pay a heavy economic toll that will take a generation or more to repair. These developments have created significant shorter-term problems that need to be addressed.

When I process this, the logical side of my brains sees a few meaningful economic developments. The first is that the world is starting to realize that you can’t rely on dictators for things that provide national security. Germany used to get 35% of its oil from Russia. That is now down to 12% and Germany supports a full embargo on Russian oil, helping to defund Putin’s war.2 This is a stunningly swift adaptation from 35% dependence to 0% in 9 weeks, which speaks to the nimbleness of capital markets. Other, more reliable oil suppliers that are friendly to Europe are able to fill the void, including the US. As Europe also weans themselves off Russian natural gas, the US and other countries will benefit there too. Secondly, current high oil prices also spur innovation in drilling technology, more efficient motors, and investment in renewable energy which over time will fix the short-term supply/demand imbalance by lowering prices and benefiting consumers and businesses. Lastly, the continued sporadic shut down of ports and manufacturing by the Chinese with their Zero-Covid policy will also cause many businesses to onshore their manufacturing to protect their critical interests, acting as a tailwind for US manufacturing. These changes may take some time, but in the end will help make the country and global economy more stable and better able to deal with shocks in the future.

It is certainly an interesting time. We have had many such times in our past with each one seeming unique and difficult to overcome in the moment, but we persevere, innovate, and emerge on the other side nimbler and more prepared to tackle the next challenge. While I am not happy about some things going on in the world, including market returns this year, there is nothing new or abnormal to this situation that we haven’t faced before. If accumulating wealth was easy, everyone would be rich. Anything worth having takes time. Begin with the end in mind and stay focused on your long-term goals.

Take care,

Marshall W. Gifford, CLU, ChFC
Founder & Senior Partner | Founder, North Star Medical Division
Gifford Financial, The MD & DDS Specialists
A Division of North Star Resource Group

2701 University Avenue SE
Suite 100
Minneapolis, MN 55414
(612) 617-6119


This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.  This information should not be relied upon by the reader as research or investment advice regarding any funds or stocks in particular, nor should it be construed as a recommendation to purchase or sell a security.  Past performance is no guarantee of future results.  Investments will fluctuate and when redeemed may be worth more or less than when originally invested.

1Our World in Data;

2Yahoo Finance;