Amidst the global political and economic turmoil, there’s been a lot of doomsday press about inflation. But what exactly is it, and why is it getting so many headlines?
Much ado about prices going up
If someone in your family has ever said “back in my day, a new car only cost $3,000…” then you already know about inflation.
Inflation refers to prices increasing over time. The price of that car has become “inflated”; the product is more or less the same, but its price has become bigger, like inflating a balloon. Inflation happens for a few main reasons. To illustrate the point, let’s continue with the example of buying a car.
Prices can increase when production costs increase, like raw materials or wages. For example, when the cost of steel used to create engines increases, then car manufacturers will increase their prices to preserve profit.
Changes in supply and demand can also raise prices. When supply goes down or demand goes up, then prices will increase. Think of the economy like one big car auction. If there are half as many cars available for potential car buyers, then car dealers will raise their prices to maximize profits. On the other hand, if twice as many people suddenly wanted to buy a car, then there wouldn’t be enough cars to go around. Buyers would bid the price up.
Both of these changes actually happened during the pandemic. The supply of cars decreased because of lockdowns, factory shutdowns, and closed ports. At the same time, demand went up since many more people wanted the freedom to escape their homes and drive to the outdoors.
Lastly, changes to the money supply can impact inflation. The money supply refers to how much cash – digital and physical – is in circulation in the economy. When central banks lower interest rates, they trigger a series of effects that increase the amount of money in circulation. Similarly, when governments increase their spending on public programs or lower taxes, they’re helping to increase the amount of cash flowing around. All of these factors – low interest rates, low taxes, and high spending – will increase inflation, and vice versa.
The most common measurement of inflation is the Consumer Price Index (CPI). The CPI has a basket of things that most consumers need, from groceries to gasoline, and compares how much the cost of this basket goes up over time.
Is inflation a good thing?
Well, yes and no.
A small amount of inflation each year is a good thing for the economy. The American institution in charge of controlling inflation, the Federal Reserve (also known as “the Fed”), typically targets 2% inflation each year in order to keep the economy growing at a healthy clip.
The logic is simple. Let’s say you want to buy that car. If you know that the car’s price would go up in the future, then you’d be more likely to buy it today. Because you’ve spent that money today, you’ve helped the car dealership to grow. When the car dealership grows, it can hire more people, create more jobs, and distribute more profit to its shareholders. It also tells car manufacturers to produce more cars; when that happens, the same process helps the manufacturers to grow. All of the car dealerships and manufacturing employees benefit, because more car sales means more money in their pockets.
In simple terms, the idea of prices increasing tomorrow helps the economy to grow today. Since private consumption accounts for about two-thirds of the US economy,¹ all of the incremental increases in personal spending add up to a big impact on the economy.
On the flip side, inflation can hurt individual consumers. If prices are going up, then the cash in your pocket will buy you more today than it will tomorrow. Economists would say that your “purchasing power” is eroding because of inflation.
Back to the car example. If you stash your saved car money under your mattress in order to buy the car in one year, then prices would rise and you would have to downsize. That’s the dark side of inflation: when it increases quickly, consumers feel the pain.
This is why most countries try to target inflation that’s just right – just enough to nudge the economy, but not too much to hurt your bank account.
But if prices can become inflated, can they also become deflated?
What goes up does not come down
The scenario when prices decline is called deflation. Deflation might seem great to you (who doesn’t want lower prices?), but it’s something that keeps economists up at night.
The trouble with deflation is what happens on a large scale. If you knew that the price of the car would be less in the future, then you’d be smart to wait to buy it. But you wouldn’t be the only person waiting to buy a car; everyone else who wanted to buy a car would also wait for prices to go down. In that case, car dealerships miss out on sales and lose profit. When that happens, they’d need to fire employees and buy fewer cars from the manufacturers to stay alive. In turn, the manufacturers would make fewer cars and need to fire their employees to cope with lower production. Since those unemployed people and shareholders also buy normal products besides cars, these impacts ripple throughout the entire economy.
So, in the deflation example, you end up with lower profits, lower growth, and higher unemployment. Money gets drawn out of the system, and the economy seizes up like a car engine without oil.
Since deflation can cause a death spiral for the economy, businesses try not to reduce prices.
Why is inflation surging now?
The pandemic had many different impacts on the economy that created a perfect storm for inflation growth.
First, it decreased the supply of goods and services around the world. Lockdowns created shortages for many different goods and services almost overnight. Since our demand for essentials like groceries and gadgets didn’t change, this meant that sellers could increase their prices.
At the same time, demand increased in certain industries, like cars, technology for teleworking, and e-commerce. This put a huge strain on suppliers. Good luck finding at-home gym equipment in April 2020.
Then, in response to the economic shutdowns, central banks and governments tried to keep the economy afloat by increasing the money supply. Governments spent trillions on relief programs like the Paycheck Protection Program and furlough scheme, while central banks kept interest rates low to incentivize spending. Both of those changes poured money into the system, which resulted in rising inflation.
In other words, we pulled every lever we could to keep the economy alive, but inflation is the price we all pay for survival.
The inflation outlook
Now that the pandemic’s worst effects are behind us, bringing inflation back into check is becoming the next goal for governments and banks around the world. Governments are trying to reduce spending, and central banks are raising interest rates to reduce the amount of money in circulation.
These changes will help reduce inflation in the future, but they take a while to have an impact. For normal consumers, this means that we’re probably going to keep seeing high prices for utilities, food, and retail essentials through the end of the year before prices begin to stabilize.
It’s not all doom and gloom, though. The US economy is forecast to grow over 4% this year – a fantastic rate for economic recovery – and unemployment rates are recovering. High inflation hurt us, but we still emerged survivors.
In the meantime, you can explore more about what inflation means for you and your money.
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