When looking at the economy and considering your finances, there’s a good chance you’ve seen the term inflation. But what is inflation? Is inflation good or bad? And how does it actually impact your finances?
Let’s take a look at some of the basics of inflation, how it can affect your money situation, and how you might make different choices depending on the rate of inflation.
What is inflation?
At a basic level, inflation is a general increase in prices. Over time, as prices increase, the economy is said to be experiencing inflation. It’s important to note that some level of inflation is expected — and sometimes even encouraged.
One of the main drivers of inflation is aggregate demand. This is the total demand for goods and services in an economy. When there’s increased demand for products and services in an economy, and production can’t quite keep up, prices tend to increase. When demand from consumers is high, and goods and services are somewhat scarce, prices increase to reflect the situation.
In the United States, a main measure of inflation is the consumer price index. The index is used to gauge how much prices have changed over time. Basically, the index takes into account the prices of certain goods and services and measures how much those prices change, on average. The CPI focuses on urban data, and also breaks out data for food, auto fuel, and utilities. When you hear people talk about core CPI, that usually means the measurement without food and gas prices factored in.
Policymakers and others look at the rate of inflation because it provides some data about the state of the economy. Consumers might pay attention to inflation because it can impact their pocket books. Higher prices mean your dollar doesn’t have as much purchasing power as it did in the past. When you consider that wage growth doesn’t necessarily keep up with inflation, you could find yourself unable to cover some of the costs associated with everyday living.
For example, from 2019 to 2020, food prices increased 3.9%, whereas prices for all items rose 1.4%. When considering your food budget, you can see how an increase in food prices — especially food prices that increase faster than overall prices — could change the way you operate your monthly budget.
When inflation is good
At first glance, it might seem as though inflation is undesirable. However, some degree of inflation can actually encourage people to spend money in the short term, boosting the economy.
Because consumer activity accounts for about 70% of the U.S. economy, policymakers believe it’s important for people to spend money. Encouraging spending is one of the ways a little inflation can be good. When people know that prices are likely to rise, they’re more likely to take advantage of lower prices and make their purchases now.
On top of that, inflation can remove the risk and worry of deflation. Deflation is when prices decrease, which can seem like a good idea at first glance, but it’s actually considered a problem when it comes to the goal of having a healthy economy.
Deflation can lead to an increase in unemployment as a deflation spiral in which prices keep falling, interest rates for debt increase, and people spend less. When people spend less in the economy, businesses don’t profit. When businesses are struggling with profit, they’re more likely to lay off workers. People who don’t have an income can’t spend their money in the economy, and that potentially leads to more deflation.
The Great Depression is a good example of a period of drastic deflation as a result of a spiral. Staving off those types of events is one of the ways inflation offers an overall good for the economy.
When inflation is bad
Although moderate inflation can be a net good for the economy and even for people, too much inflation can cause problems in the economy and start to hit our wallets in a significant way.
In general, the annual inflation target used by policymakers is 2%. Once inflation starts inching above that level, economists and policymakers tend to become a little concerned, though they might not work too hard to bring inflation down below 2% for a period of time if it will help them reach other policy goals.
A good example of inflation causing stress to the economy was during the 1980s. At the beginning of that decade, inflation was at 13.91%. Efforts to reduce inflation bore fruit and by the end of the decade, inflation was at 4.65%. Because of inflation — and especially the high cost of borrowing from lenders — consumer spending was lower, which restricted economic growth to some degree. Efforts to get inflation under control are credited with the increased economic activity in the latter part of the 1980s.
From 2006 to 2010, housing market deflation became a big issue, with the stock market crash of 2008 happening in the middle of this time period. As the economy slowed and interest rates increased, people could no longer afford homes and prices dropped dramatically. The housing market had seen price increases at a fairly good rate since 1992, but by 2006, that level had become unsustainable and demand for homes fell — and so did home values.
All this made it difficult for people who had bought their homes with adjustable-rate mortgages to refinance. When it was time for the home loan to reset to a higher rate, they could no longer afford the new payments. Unfortunately, because home values were falling, they couldn’t refinance to fixed-rate mortgages because the equity wasn’t available. Unable to afford the higher payments and unable to do a mortgage refinance, many people began defaulting. At that point, the financial institutions holding those mortgages began losing money.
A bigger issue than run-of-the-mill inflation is hyperinflation. There’s no set level for what constitutes hyperinflation, but one measure is when the monthly inflation rate exceeds 50%. Generally, hyperinflation occurs when a government decides to “print” an excessive amount of money in an effort to pay for its costs.
Although increasing the money supply can help provide a mild level of inflation and boost the economy, excessive increases to the money supply can lead to the dangerous state of hyperinflation. Part of monetary policy is trying to find the balance between money supply and inflation in a way that supports the economy.
Inflation and interest rates
In the U.S., interest-rate policy is set by the Federal Reserve, which is a central banking system. The Federal Open Market Committee is the body that determines the fed funds rate, which is the rate banks lend to each other overnight. This rate is used as a basis for other lending, and changes in the federal interest rate can influence inflation.
In general, the Federal Reserve aims to keep inflation around 2%. This is the level at which policymakers at the Federal Reserve think it’s easiest to maintain a degree of price stability as well as keep unemployment to acceptable levels. When inflation is falling, the Federal Reserve is likely to cut rates in an effort to provide economic stimulus. As the economy heats up and inflation starts to rise at a rapid rate, the Federal Reserve is more likely to increase rates in order to slow down inflation.
Rather than using the consumer price index, as the government does to set levels of Social Security benefits, the FOMC looks at the personal consumption expenditures index. With PCE, there’s a little more nuance, especially in terms of showing how people might be trading some goods and services for others. In general, CPI generally reflects higher inflation, so using PCE can mean that the FOMC takes a slower, more measured approach when evaluating the economic situation.
Inflation and unemployment
In general, when there is aggregate demand in the economy, more people are employed as companies increase production. This demand by consumers requires workers in order to produce goods and provide services. Over time, this demand can start to lead to inflation because a tight labor market means wages are supposed to increase, which can increase costs to companies.
One way to express the relationship between inflation and unemployment is the Phillips Curve. The idea is that low unemployment causes inflation, and that tweaks to the reading of the connection between inflation and unemployment can provide policymakers with a way to determine the optimal trade-off point on the curve between inflation and unemployment.
Recently, there is speculation that the Phillips Curve no longer accurately represents the relationship. In recent decades, wages haven’t risen as expected during tight labor markets, and higher inflation hasn’t been the result, even when unemployment is low.
Additionally, there are worries that the issue of stagflation may come into play. Stagflation is a situation in which inflation is high, but the economy is slow and unemployment is high. In a stagflation scenario, the normal policies adopted to reduce unemployment could potentially make inflation worse, whereas policies aimed at reducing inflation could actually make the unemployment situation worse.
How you can prepare for high inflation
One of the difficulties is preparing for a situation in which inflation could become an issue, especially if you have a relatively fixed income and the cost of living increases.
One potential solution is to consider investing money in assets designed to beat inflation. For example, a diversified portfolio that includes stocks could potentially help you offset the impacts of inflation over time. Other securities, including inflation-protected Treasurys, might also help you keep pace with inflation and at least preserve your spending power to some degree.
What causes inflation?
Inflation is often caused when economic conditions lead to increased prices. There are different conditions that can lead to inflation, including an increase in demand for goods and services, a tighter labor market that potentially pushes wages higher, and an increase in money supply.
Who benefits from inflation?
Depending on the situation, different people could benefit from inflation. In general, borrowers benefit from inflation because rising prices can make it feel easier to pay off debts or result in a comparatively good rate on borrowed money.
Additionally, those who own physical assets, such as landowners, generally benefit from inflation, as well as businesses that are able to increase prices to pay back debt that bought them more at the time they borrowed those funds.
Will the stimulus cause inflation?
Economists sometimes express concern that increasing the money supply to combat adverse economic conditions, including those surrounding the coronavirus pandemic, could lead to excessive inflation. However, there’s no agreement that COVID-19 stimulus would cause inflation. Nobel laureate Paul Krugman argues that the Biden Administration’s proposed stimulus wouldn’t cause too much inflation, and would do more to help than harm.
Inflation, or a general increase in prices, is a regular part of the economy. A mild level of inflation can be good for the economy, but excessive inflation can cause prices to increase too quickly and negatively impact your finances.
By being aware of inflation and its impact, you can make decisions about the money moves to make in a volatile market, as well as how you want to handle your investment portfolio and other areas of your finances in order to reduce the potential that inflation could negatively affect your long-term financial goals.
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