What Is Inflation: Everything You Need To Know About Inflation
Inflation refers to the increase in the price of goods and services. Read this article to know more about inflation and its different types.
Inflation is the gradual loss of purchasing power of a given currency. A quantitative estimate of the rate at which purchasing power declines can be reflected in the increase in an economy’s average price level of a basket of selected goods and services over time. A rise in the overall level of prices means that a unit of currency buys less than it did previously. Inflation is distinguished from deflation, which occurs when the purchasing power of money rises while prices fall. If you’re still not familiar with inflation, let’s delve a little deeper and learn more about it.
While the price changes of individual products are easy to track over time, human needs extend beyond one or two such products. Individuals require a large and diverse range of products as well as a variety of services to live a comfortable life. Commodities such as food grains, metals, and fuel, utilities such as electricity and transportation, and services such as healthcare, entertainment, and labor are examples.
Inflation aims to measure the overall impact of price changes for a diverse set of goods and services, and it allows for a single value representation of an economy’s increase in the price level of goods and services over time.
When a currency loses value, prices rise and fewer goods and services are purchased. This loss of purchasing power affects the general cost of living for the general public, resulting in a slowing of economic growth. Economists generally agree that sustained inflation occurs when a country’s money supply growth outpaces economic growth.
To combat this, a country’s appropriate monetary authority, such as the central bank, takes the necessary steps to manage the supply of money and credit to keep inflation within acceptable limits and the economy running smoothly.
Monetarism is a popular theory that explains the relationship between inflation and an economy’s money supply. Following the Spanish conquest of the Aztec and Inca empires, for example, massive amounts of gold and silver flowed into the Spanish and other European economies. Because the money supply had grown rapidly, the value of money fell, contributing to the rapid rise in prices.
Inflation is measured in a variety of ways depending on the type of goods and services considered, and it is the inverse of deflation, which is defined as a general decline in prices for goods and services when the inflation rate falls below 0%.
Different types of inflation
There are different types of inflation which are explained below:
When prices rise by 3% or less per year, this is referred to as creeping or mild inflation. According to the Federal Reserve, price increases of 2% or less benefit economic growth. Mild inflation raises consumer expectations that prices will continue to rise, which boosts demand. Consumers buy now to avoid higher future prices. Mild inflation drives economic growth in this way. As a result, the Fed’s target inflation rate is set at 2%.
This high, or destructive, inflation ranges between 3% and 10% per year. It is harmful to the economy because it accelerates economic growth. People begin to buy more than they need to pay much higher prices tomorrow. This increased purchasing drives demand even higher, to the point where suppliers are unable to keep up. Worryingly, neither can wages. As a result, most common goods and services are priced out of most people’s reach.
When inflation reaches 10% or higher, it has a devastating effect on the economy. Money depreciates so quickly that business and employee earnings can’t keep up with rising costs and prices. As a result, foreign investors avoid the country where this occurs, depriving it of much-needed capital. The economy deteriorates, and government officials lose credibility. Inflationary pressures must be avoided at all costs.
When prices rise by more than 50% per month, this is referred to as hyperinflation. It is extremely rare. The majority of cases of hyperinflation occur when governments print money to fund wars. Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s are all examples of hyperinflation. The United States last experienced hyperinflation during the Civil War.
Stagflation occurs when economic growth is stagnant but price inflation persists. However, this combination appears to be contradictory, if not impossible. Why would prices rise when there is insufficient demand to fuel economic growth? When the United States abandoned the gold standard in the 1970s, this phenomenon occurred. The dollar’s value plummeted once it was no longer linked to gold. Simultaneously, the price of gold skyrocketed.
Stagflation persisted until Federal Reserve Chairman Paul Volcker raised the federal funds rate to double digits. He kept it there long enough to allay fears of further inflation.
Except for food and energy, the core inflation rate measures rising prices in all categories. This is because gas prices tend to rise every summer. When families go on vacation, they use more gas. Higher gas prices raise the price of food and other items that require extensive transportation. The Federal Reserve bases its monetary policy on the core inflation rate. The Federal Reserve does not want to raise interest rates every time gas prices rise.
Inflation is the inverse of inflation. It occurs when prices fall. When an asset bubble bursts, it causes this. That’s what happened in the housing market in 2006. Those who purchased their homes in 2005 were trapped by housing price deflation. During the recession, the Fed was concerned about overall deflation. This is because deflation can turn a recession into a depression. During the 1929 Great Depression, prices fell by 10% per year. Once deflation begins, it is more difficult to reverse than inflation.
Wage inflation occurs when wages rise faster than the cost of living. It occurs in three scenarios. The first is when there is a labor shortage. The second is when labor unions bargain for ever-increasing wages. The third is when employees have effective control over their pay.
When unemployment falls below 4%, there is a labor shortage. In the 1990s, labor unions negotiated higher wages for autoworkers. CEOs effectively control their pay by serving on numerous corporate boards, including their own. All of these circumstances result in wage inflation. Of course, everyone believes that their wage increases are justified, but higher wages are only one component of cost-push inflation. This can cause the prices of a company’s goods and services to rise.
An asset bubble, also known as asset inflation, occurs in a single asset class. Housing, oil, and gold are all good examples. When the overall rate of inflation is low, the Federal Reserve and other inflation watchers frequently overlook it. However, the subprime mortgage crisis and subsequent global financial crisis demonstrated the dangers of unchecked asset inflation.
Causes of inflation
Numerous factors can cause an economy’s prices or inflation to rise. In most cases, inflation is caused by an increase in production costs or an increase in demand for goods and services.
When prices rise due to increases in production costs, such as raw materials and wages, this is referred to as cost-push inflation. The demand for goods remains unchanged, while the supply of goods decreases due to higher production costs. As a result, the increased production costs are passed on to consumers in the form of higher finished-goods prices.
Rising commodity prices, such as oil and metals, are one indicator of potential cost-push inflation because they are major production inputs. For example, if the price of copper rises, companies that use copper in their products may raise their prices. If the demand for the product is unrelated to the demand for copper, the company will pass on the higher raw material costs to customers. As a result, consumer prices rise despite no change in demand for the products consumed.
Wages have an impact on production costs and are typically the single largest expense for businesses. When the economy is doing well and the unemployment rate is low, labor or worker shortages can occur. Companies, in turn, raise wages to attract qualified candidates, causing the company’s production costs to rise. Cost-plus inflation occurs when a company raises its prices in response to an increase in employee wages. Natural disasters can also raise prices. For example, if a hurricane destroys a crop such as corn, prices may rise throughout the economy because corn is used in a variety of products.
Strong consumer demand for a product or service can cause demand-pull inflation. When there is an increase in demand for a broad range of goods across an economy, their prices tend to rise. While this is rarely a concern for short-term supply and demand imbalances, sustained demand can reverberate throughout the economy and raise prices for other goods, resulting in demand-pull inflation.
When unemployment is low and wages are rising, consumer confidence rises, leading to increased spending. Economic growth has a direct impact on the level of consumer spending in an economy, which can result in high demand for goods and services.
As the demand for a particular good or service grows, so does the available supply. As outlined in the economic principle of supply and demand, when there are fewer items available, consumers are willing to pay more to obtain the item. As a result of demand-pull inflation, prices rise.
Companies also have an impact on inflation, particularly if they manufacture popular goods. A company’s prices can be raised simply because consumers are willing to pay the higher amount. Corporations can also freely raise prices when the item for sale is something that consumers require daily, such as oil and gas. However, it is consumer demand that gives corporations the wiggle room to raise prices.
The housing market
For example, the housing market has experienced ups and downs over the years. Home prices will rise if homes are in high demand as a result of the economy’s expansion. The demand for ancillary products and services that support the housing industry is also affected. Construction products such as lumber and steel, as well as nails and rivets used in homes, may all see an increase in demand as a result of increased demand for housing.
Expansionary fiscal policy
Governments’ expansionary fiscal policies can increase the amount of discretionary income available to both businesses and consumers. Businesses may spend tax cuts on capital improvements, employee compensation, or new hires if the government lowers taxes. Consumers may also buy more goods. The government could also stimulate the economy by increasing infrastructure spending. As a result, demand for goods and services may rise, leading to price increases.
Central banks’ expansionary monetary policy can lower interest rates. Central banks, such as the Federal Reserve, can reduce the cost of lending for banks, allowing them to lend more money to businesses and consumers. The increased availability of money throughout the economy leads to increased spending and demand for goods and services.
Types of price indexes
Multiple types of baskets of goods are calculated and tracked as price indexes based on the selected set of goods and services. The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most commonly used price indexes (WPI).
The consumer price index
The CPI is a price index that examines the weighted average of prices for a basket of goods and services that are essential to consumers. Transportation, food, and medical care are among them. CPI is calculated by averaging price changes for each item in a predetermined basket of goods based on their relative weight in the overall basket. The prices which are taken into account are the retail prices of each item as they are available for purchase by individual citizens.
CPI changes are used to assess price changes associated with the cost of living, making it one of the most commonly used statistics for identifying periods of inflation or deflation. In the United States, the Bureau of Labor Statistics publishes the CPI every month and has calculated it since 1913.
The wholesale price index
Another popular measure of inflation is the WPI, which measures and tracks changes in the prices of goods before they reach the retail level. While WPI items differ by country, they typically include items at the producer or wholesale level. Cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing, for example, are all included. Although WPI is used by many countries and organizations, many other countries, including the United States, use a similar variant known as the producer price index (PPI).
The producer price index
The producer price index is a collection of indexes that tracks the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the seller’s perspective, as opposed to the CPI, which measures price changes from the buyer’s perspective.
In all of these cases, a rise in the price of one component (say, oil) may cancel out a decline in the price of another (say, wheat) to some extent. Overall, each index represents the average weighted price change for the given constituents, which may be applicable at the economy, sector, or commodity level.
The formula for measuring inflation
The above-mentioned price index variants can be used to calculate the value of inflation between two specific months (or years). While there are numerous ready-made inflation calculators available on various financial portals and websites, it is always better to be aware of the underlying methodology to ensure accuracy and a clear understanding of the calculations. Mathematically,
Percent inflation rate = (Final CPI Index Value/Initial CPI Value)*100
Assume you want to know how $10,000’s purchasing power changed between September 1975 and September 2018. Price index data can be found in tabular form on various portals. Select the corresponding CPI figures for the given two months from that table. It was 54.6 (initial CPI value) in September 1975 and 252.439 in September 2018. (Final CPI value). Plugging in the formula yields:
Percent inflation rate = (252.439/54.6)*100 = (4.6234)*100 = 462.34%
If you want to know how much $10,000 in September 1975 would be worth in September 2018, multiply the percentage inflation rate by the amount to get the adjusted dollar value:
Change in dollar value = 4.6234 * $10,000 = $46,234.25
This means that $10,000 will be worth $46,234.25 in September 1975. In other words, if you bought a basket of goods and services (as defined by the CPI) worth $10,000 in 1975, the same basket would cost you $46,234.25 in September 2018.
Pros and cons of inflation
Inflation can be viewed as either a good or a bad thing, depending on which side of the debate one takes and how quickly the change occurs.
Individuals with tangible assets priced in the currency, such as property or stocked commodities, may prefer to see some inflation because it raises the price of their assets, which they can sell at a higher rate. Buyers of such assets, on the other hand, are perhaps dissatisfied with inflation because they will have to pay more money. Another popular way for investors to profit from inflation is through inflation-indexed bonds.
On the other hand, people who own currency-denominated assets, such as cash or bonds, may dislike inflation because it reduces the real value of their holdings. Inflation-hedged asset classes, such as gold, commodities, and real estate investment trusts, should be considered by investors looking to protect their portfolios from inflation (REITs).
Inflation encourages speculation, both by businesses in risky projects and by individuals in company stocks, because they expect higher returns than inflation. An optimum level of inflation is frequently promoted to encourage spending rather than saving. If the purchasing power of money declines over time, there may be a stronger incentive to spend now rather than save and spend later. It may increase spending, which may boost economic activities in a country.
A balanced approach is thought to keep inflation in a desirable and optimal range.
Inflationary pressures that are both high and variable can wreak havoc on an economy. Businesses, workers, and consumers must all factor in the effects of general price increases when making purchasing, selling, and planning decisions. This adds another source of uncertainty to the economy because they may be wrong about the rate of future inflation.
Time and resources spent researching, estimating, and adjusting economic behavior are expected to rise to the general level of prices rather than real economic fundamentals, which will inevitably cost the economy as a whole.
Even a low, stable, and easily predictable rate of inflation, which some consider being otherwise optimal, can cause serious economic problems due to how, where, and when new money enters the economy. When new money and credit enter the economy, they always end up in the hands of specific individuals or businesses, and the process of price level adjustment to the new money supply continues as they spend the new money, which then circulates from hand to hand and account to account throughout the economy.
Along the way, it raises some prices first and then raises others. This sequential change in purchasing power and prices (known as the Cantillon effect) means that the inflationary process not only raises the overall price level over time, but also distorts relative prices, wages, and rates of return. Economists, in general, recognize that distortions of relative prices away from their economic equilibrium are bad for the economy, and Austrian economists believe that this process is a major driver of economic cycles of recession.
The important responsibility of keeping inflation under control falls to a country’s financial regulator. It is accomplished through the implementation of monetary policy, which refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
In the United States, the Federal Reserve’s monetary policy objectives include moderate long-term interest rates, price stability, and maximum employment, all of which are intended to promote a stable financial environment. The Federal Reserve communicates long-term inflation goals clearly to maintain a consistent long-term rate of inflation that is thought to be beneficial to the economy.
Price stability, or relatively constant inflation, allows businesses to plan for the future because they know what to expect. The Fed believes that this will promote maximum employment, which is determined by non-monetary factors that change over time and thus are subject to change. As a result, the Fed does not set a specific target for maximum employment, which is largely determined by employer assessments. Maximum employment does not imply zero unemployment, because there is always some level of volatility as people leave and start new jobs.
Monetary authorities also take extraordinary measures in extreme economic conditions. For example, following the 2008 financial crisis, the Federal Reserve of the United States kept interest rates near zero and pursued a bond-buying program known as quantitative easing.
Some critics of the program claimed it would cause a spike in US dollar inflation, but inflation peaked in 2007 and then fell steadily over the next eight years. There are many complex reasons why QE did not lead to inflation or hyperinflation, but the simplest explanation is that the recession itself was a very prominent deflationary environment, and QE aided its effects.
As a result, policymakers in the United States have attempted to keep inflation at around 2% per year. The European Central Bank has also pursued aggressive quantitative easing to combat deflation in the eurozone, and some areas have seen negative interest rates as a result of concerns that deflation could take hold in the eurozone and lead to economic stagnation.
Furthermore, countries with higher rates of growth can tolerate higher rates of inflation. India’s target is around 4% (with an upper tolerance of 6% and a lower tolerance of 2%), while Brazil’s target is 3.5 percent (with an upper tolerance of 5 percent and a lower tolerance of 2 percent ).
Hedging against inflation
Stocks are thought to be the best inflation hedge because the rise in stock prices includes the effects of inflation. Because additions to the money supply occur as bank credit injections through the financial system in virtually all modern economies, much of the immediate effect on prices occurs in financial assets that are priced in the currency, such as stocks.
Furthermore, special financial instruments exist that can be used to protect investments from inflation. Treasury Inflation-Protected Securities (TIPS) is low-risk treasury security that is inflation-indexed, with the principal amount invested increasing by the percentage of inflation.
A TIPS mutual fund or a TIPS-based exchange-traded fund are other options (ETFs). You’ll most likely need a brokerage account to gain access to stocks, ETFs, and other funds that can help you avoid the dangers of inflation. Because of the numerous options available, selecting a stockbroker can be a time-consuming process. Gold is also thought to be a hedge against inflation, though this does not always appear to be the case.
Extreme examples of inflation
Because all world currencies are fiat money, the money supply could expand quickly for political reasons, resulting in rapid price increases. The most famous example is the early 1920s hyperinflation in the German Weimar Republic. The nations that had won World War I demanded reparations from Germany, which could not be paid in German paper currency because it was tainted by government borrowing. Germany attempted to print paper notes, exchange them for foreign currency, and use the proceeds to pay their debts.
This policy resulted in the rapid depreciation of the German mark, which was accompanied by hyperinflation. German consumers responded to the cycle by spending their money as soon as possible, knowing that it would be worthless and less the longer they waited. As money poured into the economy, its value plummeted to the point where people would cover their walls with practically worthless bills. In Peru in 1990 and Zimbabwe in 2007–2008, similar situations occurred.
Common effects of inflation
Inflation is an economic term that refers to the sustained increase in the prices of goods and services over a given period. Inflation is seen as a sign of a struggling economy by some, while it is seen as a sign of a flourishing economy by others. In this section, we look at some of the aftereffects of inflation.
Erodes purchasing power
This first effect of inflation is simply another way of saying the same thing. Inflation is defined as a decrease in the purchasing power of currency caused by an increase in prices throughout the economy. Within living memory, a cup of coffee cost a dime on average. The price is now closer to three dollars.
A price increase could have resulted from a surge in coffee popularity, price pooling by a coffee producer cartel, or years of devastating drought, flooding, or conflict in a key coffee-growing region. In those scenarios, coffee product prices would rise, but the rest of the economy would remain largely unaffected. That example does not qualify as inflation because only the most caffeine-addled consumers would see a significant decrease in their overall purchasing power.
For prices to rise across a “basket” of goods and services, such as the one that comprises the most commonly used measure of price changes, the consumer price index, inflation must occur (CPI). When the prices of non-discretionary and impossible-to-substitute goods, such as food and fuel, rise, they can have a direct impact on inflation. As a result, economists frequently exclude food and fuel to examine “core” inflation, a less volatile measure of price changes.
Investing encourages spending
When purchasing power is declining, a predictable response is to buy now rather than later. Because cash only loses value, it is better to get your shopping done and stock up on items that are unlikely to lose value.
Filling up gas tanks, stocking the freezer, purchasing shoes in the next size up for the kids, and so on. For businesses, it means making capital investments that, in different circumstances, might have been postponed. When inflation takes hold, many investors buy gold and other precious metals, but the volatility of these assets can cancel out the benefits of their price rise protection, especially in the short term.
Over the long term, equities have been among the best inflation hedges. A share of Apple Inc. (AAPL) cost $29 in current (not inflation-adjusted) dollars at the close on December 12, 1980. After adjusting for dividends and stock splits, that share would be worth $7,035.01 at the close on February 13, 2018, according to Yahoo Finance. According to the Bureau of Labor Statistics (BLS) CPI calculator, that figure is $2,438.33 in 1980 dollars, implying an 8,346 percent real (inflation-adjusted) gain.
Assume you buried that $29 in your backyard instead. When you dug it up, the nominal value would have remained the same, but the purchasing power would have fallen to $10.10 in 1980 terms, a 65 percent depreciation. Of course, not every stock would have performed as well as Apple: in 1980, you were better off burying your money than buying and holding a share of Houston Natural Gas, which would merge to form Enron.
Raises the cost of borrowing
As these examples of hyperinflation demonstrate, states have a strong incentive to keep price rises under control. For the past century, the approach in the United States has been to manage inflation through monetary policy. The Federal Reserve (the United States’ central bank) does so by relying on the relationship between inflation and interest rates. Companies and individuals can borrow cheaply to start a business, earn a degree, hire new employees, or buy a gleaming new boat when interest rates are low. In other words, low-interest rates encourage spending and investing, which in turn fuels inflation.
Central banks can put a stop to these rampaging animal spirits by raising interest rates. The monthly payments on that boat or that corporate bond issue suddenly seem a little high. It is preferable to put some money in a bank where it can earn interest. Money becomes more scarce when there isn’t as much cash floating around. Because money is scarce, its value rises; however, central banks generally do not want money to become more valuable: they fear outright deflation nearly as much as they do hyperinflation. Rather, they push interest rates in either direction to keep inflation near a target level (generally 2 percent in developed economies and 3 percent to 4 percent in emerging ones).
The role of central banks in controlling inflation can also be viewed through the lens of the money supply. If the amount of money grows faster than the economy, the money becomes worthless, and inflation occurs. That’s what happened in the 16th century when Aztec and Inca bullion flooded Habsburg Spain, and when Weimar Germany fired up the printing presses to pay its World War I reparations.
When central banks want to raise interest rates, they usually can’t do so through simple fiat; instead, they sell government securities and withdraw the proceeds from the money supply. The rate of inflation decreases as the money supply shrinks.
Inflation discourages saving because the purchasing power of deposits erodes over time unless a vigilant central bank is on hand to raise interest rates. This prospect incentivizes both consumers and businesses to spend or invest. The increase in spending and investment leads to economic growth, at least in the short term. Similarly, the negative correlation between inflation and unemployment implies a tendency to put more people to work, thereby stimulating growth.
This effect is most noticeable when it is not present. In 2016, central banks around the developed world were unable to coax inflation or growth to healthy levels. Interest rate cuts to zero and below did not appear to be effective.
This conundrum reminded me of Keynes’ liquidity trap, in which central banks’ ability to stimulate growth by increasing the money supply (liquidity) is rendered ineffective by cash hoarding, which is caused by economic actors’ risk aversion in the aftermath of a financial crisis. Disinflation, if not deflation, is caused by liquidity traps.
Moderate inflation was viewed as a desirable growth driver in this environment, and markets welcomed the increase in inflation expectations brought about by Donald Trump’s election. However, markets fell sharply in February 2018 due to fears that inflation would lead to a rapid increase in interest rates.
Weakens or strengthens the currency
High inflation is usually associated with a falling exchange rate, though this is usually due to the weaker currency causing inflation rather than the other way around. When their currencies fall against those of their trading partners, economies that import significant amounts of goods and services—which, for the time being, is just about every economy—must pay more for these imports in local currency terms.
Assume that Country X’s currency falls 10% against Country Y’s. The latter does not need to raise the price of the products it exports to Country X for them to cost Country X 10% more; the weaker exchange rate is sufficient.
Multiply cost increases across a large enough number of trading partners selling a large enough number of products, and the result is economy-wide inflation in Country X.
But, once again, depending on the circumstances, inflation can do one thing or the polar opposite. When most of the global economy’s moving parts are removed, it appears perfectly reasonable that rising prices lead to a weaker currency. However, in the aftermath of Trump’s election victory, rising inflation expectations drove the dollar higher for several months.
The reason was that interest rates were dismally low around the world—almost certainly the lowest in human history—causing markets to jump on any opportunity to earn a little money for lending rather than paying for the privilege.
Who benefits from inflation?
While inflation provides little benefit to consumers, it can provide a boost to investors who hold assets in inflation-affected markets. Those who own stock in energy companies, for example, may see their stock prices rise if energy prices rise.
Some businesses benefit from inflation if they can charge more for their products as a result of increased demand. When the economy is doing well and there is a high demand for housing, home-building companies can charge higher prices for selling homes.
In other words, inflation can give businesses more pricing power and boost their profit margins.
If profit margins are increasing, it means that the prices that companies charge for their products are rising faster than production costs.
Furthermore, business owners can withhold supplies from the market on purpose, allowing prices to rise to a favorable level. Companies, on the other hand, can be harmed by inflation if it is caused by an increase in production costs. Companies are jeopardized if they are unable to pass on higher costs to customers in the form of higher prices. If foreign competitors, for example, are unaffected by rising production costs, their prices will not need to rise. As a result, U.S. companies may be forced to absorb higher production costs, or risk losing customers to foreign-based competitors.
In economics, inflation is and has been a hotly debated topic. Even the term “inflation” has different meanings depending on the context. Many economists, businesspeople, and politicians believe that moderate inflation is required to drive consumption, assuming that higher levels of spending are necessary for economic growth.