Inflation is the rise in prices of products and services. When the cost of basic items such as food, electricity, and transportation goes up, individuals and businesses can’t buy as much as they could before unless their income or revenue rises sufficiently. Multiply this across millions of transactions, and the entire economy feels the effects.
What causes inflation?
Economists differ on what causes inflation. What they do agree on is that the source of inflation can be classified into two broad categories: demand pull and cost push. The former essentially means that if customers want to buy more of something because of a change in preferences, uses, and other attributes, demand increases, and prices go up. The latter implies that the rising costs of doing business—such as increases in the price of raw materials or a higher minimum wage—mean that companies must pass along price increases to their customers to remain profitable.
Inflation: okay in moderation
Rising prices aren’t necessarily a bad thing: A steady, measured amount of inflation is normal—it’s considered a sign of a healthy economy. It encourages consumers and businesses to spend judiciously now, expecting prices to be higher in the future, without forcing them to get rid of cash too aggressively for fear of its losing value rapidly. It also allows companies to borrow more comfortably, as they’ll assume the money they must ultimately repay is worth less than what they’re taking in today.
But too much inflation or unexpected swings in prices can damage the economy. In the 1970s and early 1980s, inflation, as measured by the Consumer Price Index,¹ frequently reached double digits, peaking at 14.8% in March 1980.² High inflation can become a self-fulfilling prophecy, which makes it particularly dangerous.
How is inflation measured?
Although the Consumer Price Index (CPI) is more widely followed, the U.S. Federal Reserve (Fed) currently relies on data from the personal consumption expenditures (PCE) index, run by the Bureau of Economic Analysis.³ The two are closely related but have a variety of computational differences. It’s been said that “the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.”⁴ The PCE reports monthly prices for items that consumers use daily. It tracks spending on cars, clothing, healthcare, travel, and other items. (It also captures food and energy, but doesn’t include them in what’s known as the core basket, since prices for these items swing widely and can skew the average.) The change in prices for this core basket of goods and services is how the Fed keeps track of where inflation stands.
When the Fed makes changes to the federal funds rate—the base interest rate at which banks borrow money and the benchmark for short-term lending—those changes directly influence the cost of debt. Interest rates are the cost of money. When money is cheap, consumers and businesses tend to borrow and spend more, which often pushes inflation higher. When money is expensive, the opposite happens: Consumers and businesses tend to save and invest rather than spend, and inflation rates tend to fall. Fed Chair Paul Volcker famously brought inflation down from double-digit levels by raising the federal funds rate to 20% when inflation hit its 1980 peak.
In recent years, the Fed has had an explicit inflation rate target that helps inform monetary policy and has generally been more preoccupied with avoiding deflation, during which consumers and businesses cut spending in anticipation of lower prices. Since 2012, the Fed’s target inflation rate, designed to maximize employment and price stability, has been 2%. Inflation (CPI) averaged 1.8% in 2019 and came in at 1.3% in August 2020 after falling to 0.1% in May as the pandemic set in.⁴
In recent comments, though, Fed Chair Jerome Powell shifted from a specific 2% target rate to an average rate of 2% over a period of years, essentially allowing for loose monetary policy—its current federal funds range is from 0% to 0.25%—even if inflation exceeds the long-term target. Chair Powell said most recently that the Fed doesn’t expect to raise this range until inflation has risen to 2% and is on track to moderately exceed 2% for some time.⁵ This wording appears to reflect the Fed’s concern about the long-term economic impact of the pandemic, since an extended rise above 2% inflation would suggest a return to a healthier economy. “Economic projections released by the Fed this week show inflation only reaching 2% by the end of 2023, with any shift towards tighter monetary policy likely years down the road.”⁶
Why inflation targeting helps
Inflation targeting serves several purposes, including providing a nominal anchor to the inflation rate, acting as a device to coordinate market expectations, and serving as an instrument for communication between central banks (e.g., the Fed) and financial markets. “Inflation targeting is characterized by a high degree of transparency, accountability, and communication. Inflation expectations for the next one or two years affect current pricing decisions and inflation for the next few quarters. Therefore, the anchoring of inflation expectations in the private sector is a crucial precondition for the stability of actual inflation.”⁷
Other countries that target inflation
The Fed is hardly alone in targeting inflation. It is, in fact, a common practice worldwide. The Bank of Canada and Bank of England, for example, are both targeting a midpoint of 2% with a range of 1% to 3%.⁸ Many developed and developing countries have been targeting inflation, either point targets or, more commonly, ranges, for decades.
Why future rates of inflation matter today
Inflation may not seem like a concern today, but the longer-term effects of unexpectedly high inflation can be significant. If you have to budget for higher tuition rates when your kids attend college, save more for a down payment on a house, or increase your contribution to retirement savings because these things all cost more down the road, you may have to make new choices about how to save and spend today. Higher inflation can also affect portfolio holdings, especially bonds, whose fixed payments lose value in an unexpectedly inflationary environment. The effect of inflation on stocks is more ambiguous, since inflation may imply high earnings growth for certain equities.
This is where a financial professional can help, answering questions you might have around interest rates and inflation, assisting with goal setting, and suggesting new saving or investing strategies that may help you manage the potential effects of inflation.
1 Defined by the U.S. Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services," usinflationcalculator.com, 2020. 2 usinflationcalculator.com, derived from data from the U.S. Bureau of Labor Statistics, 2020. 3 federalreserve.org, 2020. 4 clevelandfed.org, 2020. 5 Comments of U.S. Federal Reserve Chair Jerome Powell, 9/16/20. 6 reuters.com, 9/18/20. 7 “Inflation Targeting,” Bank of Canada, November 2008. 8 bankofcanada.ca, bankofengland.co.uk, 2020.
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