This week the inflation report came out for August and showed a 0.1% increase in inflation from July which was not a welcome result after the Fed’s aggressive rate moves at their last two meetings. This has the markets guessing that rates must continue to rise to quench the inflation fire which, in turn, has had more negative impact on the assets that have already been suffering this year as rates have risen.
One question that investors may have is: “How can inflation be increasing when the Fed is raising rates?” And this is a good question.
One answer that a lot of CEO’s have been talking about this month is called demand elasticity.
In economics, elasticity refers to how sensitive demand is to price changes. If you can easily do without an item if the price went up, the demand for that item would be referred to as elastic. On the contrary, if you need an item (like housing or electricity) and your usage won’t change much if the price goes up then the demand for these items would be inelastic.
With that in mind, when we look at what goes into the inflation number that the Fed is trying to control, many of these items are not optional for people to pay for such as food, shelter, healthcare services, and utilities.
So while raising interest rates may have immediate effects on some parts of the inflation equation, others will be more stubborn to tame by raising rates alone. Hopefully, through multiple measures, inflation can be brought back under control, but the sharp reactions that markets have had to new news and expectations could go on for some months until more certainty presents itself.