How Does Inflation Work?
This week, the Federal Reserve's Chairman told us not to worry about inflation. How does inflation work and is he right?
Most people are familiar with the concept of inflation: the reason why gas used to cost 30¢ but is now over $3 in some places. This price increase is really an effect of inflation. The cause is the decrease in value of money. So at one point, $1 might get you one apple, but if the value of that dollar decreases such that it is only equal to, say, half an apple, we will see that reflected in the cost of one apple becoming $1.50.
Inflation is closely guarded by the Federal Reserve, and for good reason, as no one wants to pay $10 for an apple. Chairman of the Federal Reserve Jerome Powell wrote in an op-ed this week that we shouldn’t fear inflation getting out of hand. This week I wanted to talk about how inflation works and what the effects are.
What is Inflation
Inflation is measured by the rate of price changes over a period of time. Obviously people aren’t just buying one good, and the prices of different goods change at different rates. So we use different indexes to track the average prices of “baskets” of goods. For instance, the Consumer Price Index tracks the weighted average price of goods and services across over 200 categories, like food, housing, apparel, etc. For instance, for the “apples” category, they’ll track the price of the same 4 pound bag of Honeycrisp apples. They do this for a bunch of goods and services that represent the types of things people are buying most. Then we average those prices, weighted by which goods are being purchased more, and that is the price that gets tracked every month.
The current CPI has increased about 1.7% from last year, so we would refer to inflation being at 1.7%.
What Causes Inflation
The main cause of inflation is an increase in money supply. Yes, this can mean the government literally prints more money, but it usually shows up in more subtle ways. One of the most common ways to do this is cutting interest rates. By charging less to borrow money, people are more likely to take out loans and put money back into the economy by buying houses or cars (or anything with their credit cards).
It is important to note that some inflation is healthy. Prices increasing as a result of demand and increasing wages are all signs of a prosperous economy. But too much inflation can see prices for goods increasing too much. The Federal Reserve’s target for inflation is actually around 2%.
Effects of Inflation
In the past year, financial experts’ biggest worry was the coronavirus. Production and consumer spending screeched to a halt as factories and warehouses had to limit staff and consumers were losing jobs. The bounce-back was great, however, as the stock market reached all-time highs. However, this surge in the economy is one of the reasons why we could see inflation spike as well.
Since we have already begun to see an increase in economic activity due to more cities opening up, there is a possibility that the economy will “overheat.” With the influx of money from the new $1.9 trillion stimulus package on the way, one can imagine a situation where the demand for goods increases as people are eager to spend their stimulus checks and quarantine savings. If supply can’t keep up, prices could start to rise; we’ve already seen this happening in the used car market.
As mentioned, the Federal Reserve has ways of combatting inflation, but the chairman has already announced that he has no intention of raising interest rates until 2023. The reasoning is that our economy is inherently more resistant to inflation due to globalization and technology. Businesses are less able to raise prices or wages since there are foreign competitors that can undercut them if they do.
Whether these ideas are able to withstand inflation, I’m not sure. But if they couldn’t and we had to raise rates, doing so too late (i.e. when inflation is too high), can have devastating effects. In 1980, in order to combat inflation that reached 13%, the US was thrown into a recession when the Fed increased interest rates, raising unemployment to 10%, the same level as during the Great Recession.
While it’s clear that a recession is bad and that a struggling retirement portfolio is obviously bad, it’s not as obvious that when an economy dips, it’s the marginalized communities that are impacted the first. Unemployment does not have to reach 10% for those who need their jobs the most to lose them. Prices do not have to increase by 13% for those who make minimum wage to struggle financially.
And I think this is exactly why we should care about financial issues like this. Even though I’m not exactly sure what there is to do here — the Fed is going to do whatever they’re going to do — I do know that our economy is a sum of its parts, and everyone is impacted when one group struggles. I just wanted to share a bit about how inflation works, and now, with a new government in charge and new fiscal policies, I think it’s necessary to just be aware of how the actions during the next few years can impact our economy moving forward.