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What You Should Know
Inflation is generally measured by two indexes tracked as “basket of goods” proxies of overall price activity, the Consumer Price Index (CPI) and the Producer Price Index (PPI). The Department of Labor’s Bureau of Labor Statistics publishes both figures, along with a core CPI figure that strips out the “more volatile” food and energy components. Since we all need food and energy, some choose to ignore the “core” figure.
Inflation can be caused by changes in demand, supply, or a combination of the two. Demand-based, or demand-pull, inflation occurs when people have too much money or too much cheap money (that is, easy credit), and it chases a fixed level of goods and services. The antidote is to make money more expensive by raising interest rates or decreasing the amount of money available, both normally well in the control of the central bank, in our case the Federal Reserve. Inflation can also be caused by shortages of a commodity, like oil, where price spikes will eventually trickle into the entire economy. Or they can be a combination of the two, as seen in early 2008 when both a supply shortage and a demand increase driven mostly by China drove energy prices higher with a fairly rapid trickling through the economy.
Depending on the amount and consistency of inflation, it can have positive or negative effects on the economy. Too much inflation discourages saving, as the purchasing power of that saving will deteriorate. High inflation may create shortages as people “stock up” in anticipation of rising prices. It creates fear and uncertainty in the business world, delaying business investment, because no one can predict what raw materials, labor, and other “inputs” will cost in the future.
Modest inflation—in the 2 to 4 percent per-year range—is seen as a good thing. Why? Because it’s better than the opposite: deflation (see #19 Deflation). Moderate and predictable inflation is thought to help avoid recessions and sharper business cycle reversals. Inflation also helps borrowers, for the dollars they will use to pay back debts will be worth less in the future, thus easier to come by, as most debts do not get larger with inflation.
It’s interesting to note that inflation and deflation once occurred in sharp and unpredictable cycles. More recently, central bank intervention has moderated those cycles, and has avoided deflation altogether, at least in the United States, since the Great Depression. The moderate and steady inflation rates enjoyed particularly since the oil shocks of the 1970s have created a favorable business climate. See Figure 3.1 for a long history of inflation rates. (It should be noted that this chart is the same as presented in the first edition and only takes us through 2006, but the 356 years before that remain instructive)
Figure 3.1 U.S. Historical Inflation Rate
Source: Wikipedia
Data Source: John J. McCusker, How Much Is That in Real Money?: A Historical Commodity Price Index for Use as a Deflator of Money Values in the Economy of the United States, American Antiquarian Society, 2001; Consumer Price Index (from 2001 forward)
Why You Should Care
Inflation can be one of the biggest enemies to your finances and financial plans, particularly if you save money. Those savings will be worth less over time if the rate of inflation exceeds the interest rate your savings earn. Most recently, wage increases have not kept up with inflation, another cause for concern. Hard assets like gold and real estate are thought to hold up better in inflationary times, but obviously real estate is no longer as safe a haven as once thought. These days, people have learned to fight inflation by consuming less or buying less expensive goods and services, but that isn’t a strategy for the long term. Inflation remains a persistent threat to finances for all of us, especially as central banks “fix” economic problems by increasing credit and the money supply. Although inflation hasn’t been a big news headline lately, it’s important to watch inflation closely—particularly in the things you tend buy a lot of, including food, health care, and energy.
19. DEFLATION
If inflation is bad, doesn’t that mean that deflation is a good thing? It sure would seem that a decline in the prices of goods and services would be good; our money would be worth more, and we’d all be able to buy more for our money. What’s wrong with this picture?
What You Should Know
Actually, economists hate deflation, which is defined as a sustained, across-the-board decrease in prices, a negative inflation rate. Why? Because, quite simply, if people perceive that prices will go down, they’ll stop spending and wait for those prices to go down further. Businesses will do the same thing. Furthermore, businesses won’t be able to sell their products for as much money in the future, and are using relatively more expensively priced materials and labor they have to buy today to produce them in advance of that sale. So for the business, profits suffer; for everybody, the slowdown caused by people hoarding money anticipating it will become worth more later ends up sapping the economy.
Reduced consumer and business spending can cause a severe business slump; in fact, deflation is typically only observed during the most severe business crises, including the Great Depression and the so-called “lost decade” in Japan that started in the 1990s. In Japan, a large inflationary bubble driven by real estate and irresponsible lending unwound. Prices started to drop and banks stopped lending, starting a downward spiral of decreased consumption and spending that didn’t let up until recently, when the central Bank of Japan took rather drastic measures—that is, printing lots of money—to artificially decrease the value of the yen and rekindle mild inflation.
The good news is that we haven’t really seen deflation lately, although there was a persistent threat of it as a consequence of the Great Recession. Figure 3.1 illustrates the fact that deflation occurred considerably more often in the past.
Why You Should Care
For most individuals, deflation isn’t that scary, unless it is prolonged and leads to an extended business slump. That, of course, means a more severe contraction of business, and additional job losses. The bigger problem can be the actions of central banks like the Fed, which go so far to avoid deflation, they end up sowing seeds of a stronger inflation. That was the big worry in the wake of the Great Recession. Bottom line: the less you hear about deflation, the better.
20. STAGFLATION
As the name implies, stagflation is a painful combination of inflation and economic malaise. Since the “typical” cause of inflation is excessive demand in an overheated economy, the combination is a bit surprising for economic purists. But the occurrence of both together happened in a big way in the late 1970s, when high inflation was accompanied by high unemployment, and it continues to be a threat to the current economy both in the United States and abroad (see #10 Misery Index).
What You Should Know
Stagflation generally has two causes. One is a supply shock, as in the oil shocks in the late 1970s, and to a degree, the oil price spike in 2008. Inflation is caused more by supply factors than general demand, and so the traditional means of fighting inflation through monetary policy (reducing money supply, raising interest rates) don’t work—they only serve to slow the economy while not solving the supply shortage. Stagflation can also be caused by excessive regulation, or by other practices that make economies inefficient, combined with inflationary monetary policy. Such has been the case in Europe and Latin America from time to time.