It is very common to hear the success of the market being touted right now, as new all-time highs are being flirted with- but as people always point out when it is convenient for them: the market is not the economy. The inflation lag-effect sticks around for a while as the level begins to taper off and interest rates begin to drop, so understandably there is a feeling of ‘growing pains’ in the economy- this is all part of the economic cycle.
Bluntly put, not much effort seems to be placed in understanding this, as it is easier to just be happy with the market or unhappy with the economy, or visa versa.
The following is a massively easy way to understand the effect of inflation and purchasing power-
keep in mind:
If a dollar is worth less, more ‘dollars’ are needed to obtain the ‘thing’. If a dollar’s worth goes from $1.00 to $0.90- the ‘item’ goes from $100 to $110. The item may not be 10% greater in value, but in relation to the value of the medium used to purchase it.
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John had a chicken named Clara that laid a dozen eggs every day. At the market, he sold each egg for 100 pennies. But over time, everyone had more pennies in their pocket and prices in the village began to rise. Soon, John found he could sell his eggs for 120 pennies each.
Excited, he thought, “Clara’s eggs are worth more now!”
But his neighbor Martha pointed out, “No, John. The eggs aren’t worth more — the pennies are worth less. If 120 pennies can now only buy what 100 pennies could before, it's just taking more pennies to buy the same things. The price went up by 20%, but not because the eggs gained value — the pennies lost their purchasing power.”
John realized that while he had more pennies, they were not able to buy for him what they could before.
As time passed, the pennies began to regain their strength. With the currency stabilizing, the cost of buying a chicken started to come down. Seeing this, people in the village began to wonder: “Why buy eggs at a high price when the cost of a chicken — which lays eggs every day — is now much more reasonable?”
John tried to keep selling his eggs at 120 pennies, but soon the market set a different price. Villagers realized they could buy a chicken for less and get fresh eggs themselves. Demand for John’s eggs dropped, and he had to lower his price to attract buyers.
Martha explained, “John, when the pennies were weak, it made sense for people to buy your eggs at a higher price. But now that the pennies are stronger, and buying a chicken is cheaper, the value proposition has changed. The market has decided that your eggs are worth less than you were asking."
John nodded, seeing the lesson. “So, even if I kept my price the same, the market adjusted because the true cost-benefit changed. My eggs are now worth less because people have better options.”
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A strong dollar widens the trade deficit, as it becomes easier for U.S. consumers to buy foreign products, and more expensive for U.S. products to be purchased internationally. Ultimately, a stronger dollar makes for more affordable day-to-day expenses. This does come with the possibility of a trade-off that market returns are reduced if compared to the returns of a weaker dollar environment.
On one hand, elevated interest rates attract foreign investors, but a stronger dollar reduces the inflated environment, which may have infiltrated the stock market and equity prices.
With U.S. interest rates being at their highest since the 2008 financial crisis, the dollar has been on a downward trend over the past 2 years. Interest rate cuts being warranted based on tapered inflation rate, would only further reduce the dollar’s value- which is currently sitting at its relative value it held pre covid.
This will be the next task for the Fed to tackle and manage.
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