Financial Review

Basic Economics – Inflation

It’s time now for another edition of “What you need to know about basic economics.” Today we tackle inflation, which is another way of saying prices are rising; more specifically, it is the rate at which the general level of prices for goods and services is rising. Inflation is usually expressed on an annual basis, so a 2% inflation rate means that prices across the economy as a whole are 2% higher than 12 months ago. If something cost you $100 a year ago, it would cost $102 today. Actually, the inflation rate is currently at 1.4% for the 12 months through January 2016.

 

There are several ways to measure the economy. The most familiar gauge is the Consumer Price Index, or CPI, which measures prices at the retail level. The CPI is used to determine the Cost of Living Adjustment, or COLA, which determines if Social Security benefits are increased to reflect changes in inflation. The Producer Price Index, or PPI, measures prices at the wholesale level, including the cost of raw materials and the prices manufacturers charge retailers. The Federal Reserve’s preferred gauge is the personal consumption expenditure, or PCE, price index.

 

Inflation can help illustrate whether an economy is in good health, or whether it is overheating or slowing down too much. Steady, moderate, and predictable price increases are a hallmark of a stable and healthy economy, and that is the goal of governments and central banks. Countries with a high rate of growth can absorb higher rates of inflation. The Federal Reserve has set a target of 2% inflation, and the current rate is 1.4%, so that indicates the economy is a little slow or weak right now. If inflation gets too high, the economy can be trapped in an inflationary spiral with prices rising exponentially, or even go to hyperinflation, which is generally considered as prices rising 50% or more – per month. Examples of hyperinflation are Weimar Germany or more recently, Zimbabwe. I actually have a $20 billion dollar note from Zimbabwe on my desk. In the 1970’s the US had inflation around 20% annually, combined with weak or stagnant economic growth. It was called stagflation. In short, inflation can wreck an economy.

 

And the rate of inflation can tell us about the overall health of the economy. Think of inflation as the cost of living, compare it to household incomes; if incomes are going up faster than the rate of inflation, the standard of living is improving. If inflation outpaces household income, the standard of living is falling. When an economy is growing fast, workers receive pay increases; they spend their incomes on more goods and services; as demand increases, prices tend to rise in response to increased demand. This is known as wage push inflation. Inflation can also result from the amount of money people have at their disposal. If the money supply grows there will be more money chasing the same volume of goods, or possibly fewer goods, which will push the prices higher. The money supply can grow because banks lend out more money or because the central bank prints more money.

 

Inflation erodes the value of money and it also encourages spending; buy it now because it will be more expensive tomorrow or next year. Inflation also erodes debt because the debt is repaid with money that has less purchasing power in the future. Governments know this and have, at times, allowed inflation to increase, effectively reducing the amount of money they owe. Inflation also encourages investment because if you just stuff your cash in the mattress, inflation means your purchasing power declines over time; so you look for a way to grow the money at a faster rate than the decline of purchasing power.

 

And so interest rates are analogous to the rate of inflation. Over the years, people have come to expect to earn interest close to, or slightly better than the level of inflation. However in many countries, from Japan to the Eurozone, we now see negative inflation, where the banks charge people to store their money. The idea is that if people have to pay to park their money, they will instead, invest that money. So far it isn’t working out; when faced with negative interest rates many people are pulling money out of banks and stuffing it under the mattress, or more specifically buying their own safe.

 

The problem with excessive inflation or deflation is that it destabilizes economies. When businesses or households lose confidence in stable prices, they avoid investing and saving, and economies can come to a grinding halt. This is why the Federal Reserve has a dual mandate: first, to achieve maximum employment (which we talked about last week), and second, to maintain price stability (which is another way of saying a nice steady rate of inflation). To achieve price stability, one of the major tools the Fed uses is interest rates; when they raise interest rates, the idea is that it will slow the economy and reduce the rate of inflation, when they lower interest rates, it will encourage debt and speed up the economy and increase the rate of inflation. It is no easy task. Inflation has been described as toothpaste, once it’s out of the tube, you can hardly get it back in. Meanwhile, in a deflationary or disinflationary environment, trying to create a little more inflation has been compared to pushing on a string. The Fed is looking for inflation at that perfect level where it’s not too hot and not too cold, sometimes called the Goldilocks economy. It doesn’t always work out exactly as planned but that’s what the Fed will be trying to achieve when they meet next week to determine monetary policy.

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