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By John W. Schoen Senior Producer
msnbc.com
updated 10/1/2007 7:51:17 PM ET 2007-10-01T23:51:17
COMMENTARY

Last month's half-point interest rate cut by the Federal Reserve got a lot of attention. One reason is that setting rates is about the most important job of any central bank as it tries to keep the economy from slipping into recession without letting inflation get out of control.

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That has some readers wondering: Just what are recession and inflation? And how are they related?

I am trying to explain what recession and inflation mean to my kids. Can you put it in simple terms so that they can understand?
Lisa H. Albuquerque, NM

Recession and inflation are the two big bogeymen that keep Federal Reserve Chairman Ben Bernanke and his colleagues at the Fed up at night. Their job is to keep interest high enough to tame inflation without causing a recession. Steering between the two is a lot harder than it looks.

A recession is when the economy stops growing and goes into reverse. Instead of adding new jobs, there are fewer jobs. Instead of companies making more money than the year before, they make less. Consumers spend less because more of them are out of work. Companies sell even less stuff, make less money and around it goes.

Usually, recessions correct themselves when interest rates go down. Rates go down when there's less demand for borrowing, which is what happens in a recession. Consumers use their credit cards less and businesses don’t need to borrow to build a new plant or open a new office to meet new demand. With lower demand for loans, lenders lower interest rates. Think of it as cutting the price of money and having a big sale.

Those lower rates make it easier to borrow and spend. And as consumers and businesses borrow and spend, the economy gradually starts expanding again. The Federal Reserve tries to stay ahead of the game by lowering rates before recession hits — that’s what it did last month. But the cure can take time. And when the recession is caused by the collapse of a big industry — like housing — it can be harder to avoid. Housing declines have preceded most of the big recessions in the last half-century.

Inflation is a different animal — it’s an increase in prices. There are several causes, but it typically happens when an economy gets going too fast. Everyone is so flush with cash (or credit) that consumers spend freely and businesses expand rapidly. When they do, they’re competing for the same goods and labor. If supplies are limited — and demand stays strong — prices go up.

That’s what happened with home prices. More and more people were able to borrow, so there were more buyers able to spend more for each residence. Strong demand is also driving up the price of oil. Every economy in the world needs more and more of it to grow, but oil companies aren’t finding new oil fast enough to keep up. Food prices worldwide are also rising as more crops are diverted to making biofuels like ethanol and biodiesel. A shortage of workers with certain skills means companies have to pay more to find them and keep them.

One way for your kids to think about supply and demand is log on to eBay and shop for concert tickets. No matter how good the seats are, if it's a band no one wants to see, they’ll go for pretty cheap. But if the hottest band is sold out, and you want two front-row seats, demand will drive up the winning bid — often higher than the original ticket price.

If inflation gets started, it can be hard to control. As prices rise, consumers demand higher wages from their employers, who pass along the higher labor cost by raising their prices for good and services. That makes it harder for consumers to make ends meet, so they ask for more money, etc. Round and round it goes.

High inflation can be worse than recession. Everything costs more every year, so if you’re on a fixed income, you have less and less buying power. And inflation is terrible for savings and investments: If you have $1,000 in the bank today, it buys less tomorrow and even less next month.

The only known cure for inflation is higher interest rates: By making it expensive to borrow, you slow down demand and — with any luck — prices slow down too. This would be like having PayPal charge huge fees to buy those eBay tickets. Fewer bidders means slower price increases.

The last time inflation really got out of control was in the 1970s. The problem was that the economy stalled at the same time, producing something then called “stagflation” (stagnation plus inflation). At that point, the Fed was stuck: If it lowered rates, inflation got worse. If it raised rates, the economy got worse.

Eventually, after trying everything else (including government-mandated wage and price controls, which didn’t work), the Fed jacked up rates to 20 percent. Financial markets got clobbered. People on fixed incomes got hammered. Few people could afford to buy a house because mortgage rates were so high.

It wasn’t until the recession of 1980-82 that inflation was finally killed. Soon thereafter, the economy bounced back and the stock market began one of the strongest bull runs in history.

My 401(k) says I have a 45 percent share holding in "large-cap stocks." What are they?
— Wayne C.  Reno, Nev.

"Large cap" is short for large capitalization, which just means these are the biggest companies out there. (Capitalization refers to the total value of all stock issued by a given company.)

Why should you care? Though we tend to think of “the stock market” as one big, unified place where people buy and sell stocks (which it is), it’s also a collection of investors who specialize in different types of stocks: big, little, international, old and failing, new and growing rapidly, etc. These are sometimes referred to as different “asset classes.” Even when the overall stock market — the collection of all these subgroups — is going up, these different types of stocks may behave very differently.

Big “institutional” investors, for example, may favor big-cap stocks because they have so much money to invest they would overwhelm trading in a company with a small market capitalization. Small cap stocks can be more volatile: Because the total value of one company’s shares is relatively small, money flowing in and out of those shares can have a bigger impact that they would on a much larger company.

The other reason for making these distinctions is that you can also track the relative performance of these different types of stock — and see that they don’t always move together. If U.S. big cap stocks hit a weak patch, the Dow Jones industrial average — which tracks just 30 of the biggest-cap stocks — may go down. But the “broader market,” as measured by the 500 biggest stocks (the Standard & Poor's 500), may be doing just fine. Likewise, international stocks may be on a tear even though U.S. stocks are limping along.

That’s why money managers recommend “asset class diversification” — a fancy term for not putting all your eggs in one basket. The mix depends a lot on how much risk you feel comfortable with. Large caps can be dull and boring, but some people like dull and boring. By figuring out how your comfort level with risk, you can come up with a balance of asset classes that lets you sleep at night.

And by spreading your money around asset classes that don’t march to the same drummer, you can lower the risk that any given market move will clobber your portfolio.

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