What is inflation and what causes it?
This article was originally published on Bankrate.com by Karen Bennett.
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Inflation is when the dollars in your wallet lose their purchasing power — either because the money supply has dramatically increased or because prices have surged.
It’s an economic phenomenon that has a nasty reputation among policymakers, investors and consumers alike. That’s more so now than ever, with price surges on everything from food, housing and vehicles to clothing, medical care and gasoline, according to data from the Labor Department released in March.
Key Statistics
The consumer price index, a measure of inflation, rose 0.8 percent in February compared with January.
The index has risen 7.9 percent during the past year, reflecting the largest 12-month increase in 40 years.
Gasoline: The gasoline index rose a considerable 6.6 percent in February, and prices at the pump continued to climb in March, with the national average surpassing $4 a gallon.
Food: The cost of keeping food on the table also continued to climb, as the food index rose 1 percent in February — the largest monthly increase since April 2020 when prices climbed in response to the coronavirus outbreak.
Shelter: The shelter index climbed 0.5 percent in February, with the rent index up 0.6 percent and the index for lodging away surging 2.2 percent.
Vehicles: The prices for used cars and trucks have skyrocketed by 41.2 percent in the past 12 months, while the new vehicle index has risen 12.4 percent over the same period.
Table of Contents
What is going on with inflation?
How much inflation is too much inflation?
5 ways to protect your money from inflation
What is inflation?
Inflation occurs when the cost of goods and services in the economy goes up over a sustained period of time. Yet, distinguishing actual inflation from just a price jump can get pretty tricky — because both are different.
Inflation doesn’t happen overnight, and it also doesn’t happen when the cost of one particular good or service goes up. Say you go to the grocery store and buy a dozen eggs for $2. Then, the next week, that same product is now $4. That alone doesn’t count as inflation, as prices in the financial system constantly fluctuate.
From an economics perspective, inflation applies to the broader picture. So while prices on some items can definitely be inflated (think: college costs), it doesn’t equal what economists mean when they say inflation, even though your wallet can surely feel that squeeze.
“We may see prices rise on certain things like gas or milk, but it’s not necessarily inflation unless you see prices rising sort of across the board, across many different products and services,” says Jordan van Rijn, who teaches agricultural and applied economics at the University of Wisconsin–Madison.
Though the Federal Reserve hasn’t established an inflation target, policymakers have set an acceptable level of inflation at about 2 percent annually. Inflation has topped 2 percent repeatedly during the past two decades.
Since 2000, there have several months during which inflationary measures increased significantly year over year:
How inflation is measured
Consumers
The way inflation is measured depends on the gauge. For consumers, the most important price tracker tends to be the Labor Department’s consumer price index. Policymakers at the Federal Reserve, however, closely follow the personal consumption expenditures index, from the Commerce Department. The indexes are broadly similar and track the same trend, though the consumer price index tends to show higher rates of inflation over time.
Generally, both gauges follow a wide variety of consumer products that reflect typical household purchases, which can be anything from appliances and furniture, to food, apparel and utilities.
Some households might have a higher inflation rate than others, depending on what items they’re buying. Lower-income households, for example, may spend a greater percentage of income on housing, food, gasoline and utilities, meaning they’re more affected by rising prices.
“If 50, 60, 70 percent of your money goes to paying a mortgage or rent and those prices are rising, you’re going to certainly be hit a lot harder,” van Rijn says. “Certainly people spending a lot of money on groceries and gasoline, they’re going to still feel the impact of a big increase in headline inflation.”
Data Collectors
Data collectors create an index that tracks the consumer staples’ costs and multiply it to get what’s called a base period. Then, they compare that index with different time periods to get what’s called the inflation rate. Measuring quarter to quarter provides a quarterly inflation rate, while year to year gives an annual inflation rate.
But some categories tend to be more volatile than others. Food and energy, for example, experience sharp swings month to month. Sometimes, it’s best to strip those categories from the data, in what’s called a core inflation rate, which helps eliminate some of the noise. Over time, however, both core and headline inflation tend to follow the same path.
What causes inflation?
Economists like to lump the typical inflation causes into two categories: demand-pull and cost-push inflation. They sound wonky, but they reflect experiences that many Americans are familiar with.
Cost-push occurs when prices increase because production is more expensive; that can include rises in labor costs (wages) or material prices. Companies pass along those higher costs in the form of higher prices, which then cycles back into the cost of living.
On the flip side, demand-pull inflation generates price increases when consumers have resilient interest for a service or a good.
Such demand could result from things like a low jobless rate, a high savings rate or strong consumer confidence. A higher demand for products causes companies to produce more to keep up with demand, which, in turn, could lead to product shortages and price surges.
“You could have an economy that revs up very quickly and you end up with demand-pull inflation, where there’s too much money chasing too few goods and services,” says Greg McBride, CFA, Bankrate chief financial analyst. “Cost-push is where input costs increase and that affects the price for goods and services.”
What’s going on with inflation?
The cost of goods and services has steadily increased since World War II, when modern data collection was first made available. That’s partially just because the economy has grown. But economists like to think about price gains by tracking how much they’ve increased or decreased from the prior-year period. In recessions, the year-over-year inflation rate tends to fall, reflecting disinflationary pressures as millions of consumers remain out of work and demand is subdued. In recovery periods, the inflation rate tends to pick up, reflecting higher demand and wage gains as individuals find employment again.
High inflation was last a major problem during the 1970s and ‘80s — reaching 12 percent in 1974 and 14.5 percent in 1980 — when the central bank moved too slowly to adjust interest rates amidst big government spending and two oil-price shocks. The Fed took action by raising interest rates to get inflation back in line. By late 1982, inflation was down to 5 percent.
Since then, inflation hasn’t proved much of a threat, and price gains have actually been tepid at best, mainly due to disinflationary factors from globalization, fewer labor unions, technological innovations and overall stagnant wage growth.
In recent times, the coronavirus pandemic, supply chain problems, worker shortages, a surplus of consumer cash and the Ukraine-Russia conflict have all contributed to inflation reaching a 40-year high. Prices for things like gasoline, food and housing have increased significantly since 2019. The price of crude oil rose 83 percent over the past 12 months, according to March 7 data from the Federal Reserve Bank of St. Louis. Oil price spikes can cause surges in the prices of gasoline as well as the thousands of products made from oil and natural gas, such as:
Aspirin
Computers
Eyeglasses
Tires
Shampoo
Solar panels
Synthetic fabrics
Toothpaste
Trashbags
Tubing
Upholstery
Vinyl flooring
Since oil is a component in fertilizer and used in farming, the price of food is also seeing increases.
Price surges that were brought on by the pandemic and supply shortages may abate in coming months, causing prices for energy, transportation and goods to come down. Factors like the Ukraine-Russia conflict, however, still point to uncertain economic conditions ahead. In all, the economy is running very hot, with consumers flush with cash and eager to spend it on cars, homes and furniture, while manufacturers struggle to keep up, faced with widespread labor shortages and supply chain hiccups.
The higher prices of goods and services due to inflation are costing the average household $276 extra a month, by some estimates.
An inflation calculator is a simple way to compare the buying power of money during different periods, by inputting a dollar amount and selecting the months and years for comparison. For instance, $10 in February 2000 had the same buying power as $16.71 in February 2022.
Consequences of inflation
The consumer inflation rate as measured by the consumer price index in February 2022 rose 7.9 percent from a year ago, reflecting the largest 12-month increase since 1982.
Consumers and policymakers wouldn’t be so fixated on inflation if it didn’t prove to have consequences — for both individual households and the broader economy.
In a high-inflationary environment, there are few places to hide. Think about the money you have sitting in your wallet or in your bank account. In a high-inflationary environment, you wouldn’t be able to buy as much with it as you used to. Taking into consideration the fact that two-thirds of U.S. economic growth is consumption, that could threaten the vibrancy of growth.
“If prices are rising faster than wages, which tends to occur in cases of high inflation, basically, that means people have less money to spend, less real purchasing power,” the University of Wisconsin’s van Rijn says. “It’s almost like having a pay cut.”
One of the many groups put into a precarious position by inflation are retirees on a fixed income, who may feel the need to cut back on purchases or resort to riskier investments in hopes of generating more income.
Retirees are “at this moment in their lives they really want to reduce their exposure to risky assets and be in a bond portfolio,” says John Cunnison, CFA, chief investment officer at Baker Boyer Bank. “But if inflation begins to run, those bond portfolios, they’re really not going to perform well. They have very limited options in a period of high-sustained inflation.”
Other groups often hit particularly hard by inflation include business owners, who can struggle to stay afloat. If the cost of borrowing also rises, anyone looking for a loan may also have trouble finding affordable rates, which can further slow down the economy.
How much inflation is too much inflation?
A small amount of inflation is actually a good thing. Typically, that’s thought of as a 2 percent increase year over year, at least in the minds of officials on the U.S. central bank.
“That basically gives the economy the ability to slowly raise prices,” Cunnison says. For companies, they can slowly increase people’s wages. You’re really looking at the goldilocks inflation, a not too little, not too much.”
But increases in inflation that are too drastic could erode consumers’ purchasing power, stifle demand for goods and services and threaten companies’ profitability — which may force the Fed to raise interest rates to cool down the economy.
Even the mere expectation of higher prices can be a bad prophecy. If consumers start expecting prices to pop, they’re more likely to start panic buying and demanding higher wages. Those two forces combined prompt companies to increase prices, creating the very phenomenon consumers were worried about. “The tricky thing with inflation is, a lot of it is psychological; it depends on expectations of what inflation will be in the future,” says van Rijn, the economics professor. “If people think inflation will be high, prices are going to continue to rise. If you’re an executive setting wages at your company, that depends a little bit on your expectations for how much prices are going to increase next year. As wages go up, then the same thing happens with businesses — they’re going to start raising their prices.”
5 ways to protect your money from inflation
Technically speaking, higher inflation should always be something that’s factored into your wallet, experts say. But another way of looking at it means periods of higher inflation shouldn’t change your strategy all that much, particularly if you’re an investor.
1. Equities
Investing in equities may provide a safe haven from inflation, since certain companies still stand to make profits in inflationary times, which in turn may cause their stock prices to rise. In general, avoid parking too much cash on the sidelines in fixed-income investments like government bonds. Experts typically recommend getting income from across your portfolio, including from dividend-paying stocks, preferred stocks and real estate investment trusts.
2. Inflation-indexed bonds
Another beneficial strategy can be incorporating inflation-indexed bonds, the most common being Treasury-Inflation Protected Securities (TIPS), which protect you from inflation by design. They pay a fixed interest rate every six months and an inflation adjustment on a semiannual basis, which applies to the bond’s face value, rather than its yield.
3. Gold
Gold is often viewed by investors as a safe haven during times of inflation or low interest rates, thanks to its proven track record of gains. If you don’t want to actually buy gold and keep it in your home, a convenient alternative is purchasing it through an exchange-traded fund (ETF), which allows you to invest in physical gold or gold mining stocks.
4. An adequate emergency fund
Periods of higher inflation might seem like the wrong time to prioritize saving, but building up an emergency fund of six to nine months’ worth of your expenses is still a wise idea, considering that economic uncertainty rises along with inflation. After that, higher inflationary environments are a particularly important time to make sure that you start searching for a better return — especially for consumers, who risk losing purchasing power.
5. A house
Though mortgage rates recently climbed to more than 4 percent after bottoming out at 2.93 percent in January 2021, those who acquired a fixed-rate mortgage at low rates were able to secure cheap funding for up to 30 years. Though property taxes may increase, you can rest assured your fixed-rate mortgage payment will remain the same — unlike the price of rent, which isn’t immune to inflation — even as most of your other expenses continue to increase.
– Staff writer Sarah Foster contributed to this story.
The post What is inflation and what causes it? appeared first on In The Know.
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