Inflation is a bad thing, right? It make things more expensive, right? For those of us of, let’s say, a certain vintage, we recall the runaway inflation of the late 1970’s and early 1980’s. So why does the Federal Reserve – in charge of managing the country’s currency and value thereof – actually try to create inflation? It’s called the inflation targeting and it matters to your money.
What is inflation?
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. The key phrase here is “goods and services” which translates into “the things I buy”. Spoiler alert: not all of the “things I buy” have the same rate of inflation.
When the price level rises (i.e. when inflation is present), each unit of currency - in our case the US Dollar - buys fewer goods and services. Stated another way, the same amount of goods and services (the things I buy) costs more units of currency (i.e., dollars, but feel free to use “units of currency” at your next dinner party, it will make you sound really smart but nobody will want to talk to you for the rest of the night). But if my salary from my job or income from my business is growing at the same time, who cares if the things I buy cost more?
It’s nominally very real
Two key concepts that you must know when thinking about inflation its effects are “nominal” and “real”. “Real” values (the cost of producing a widget or your monthly salary for example) have been adjusted for inflation while “nominal” values have not. So, if your annual income increased by 5% in a given year (nominal) and the inflation rate for that same year was 5%, how much real income increase did you experience? Choose from A) Bupkis, B) Nada, C) Zero and D) All of the above. “Purchasing power” is another term that describes this real versus nominal phenomenon. In our previous example, your annual change in purchasing power is also zero – the inflated dollars that you earned were just enough to offset the inflated cost of the things you buy.
The evil that you know
So why does the Federal Reserve actually try to create a situation where you need to continuously earn more money to pay for continuously higher prices for the things you buy? The main reason is that inflation is better than deflation. Deflation is the opposite of inflation. It describes a situation where the general level of prices are falling . This may sound like a good thing but the reason that prices are falling is usually because there is a lack of demand for a given product driven by a lack of money to pay for the product driven by a lack of jobs to make the money to pay for the product. Also deflation can be very difficult to cure (just ask Japan) because it creates an expectation that future prices will be lower thus motivating buyers to wait for those lower prices thereby causing more price declines.
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An inflation rate just for you
Here is where things get a bit tricky. The Fed’s target rate of inflation (currently 2% annually) is a target for all prices generally in the market reflecting everything from the cost of a gallon of gas to the price of a movie ticket. In reality, the rates of inflation for individual goods and services (the things you buy) can and do vary wildly. This means that your personal rate of inflation is dictated by the mix of things that you choose to buy (a TV) and the things you are forced to buy (food). To illustrate this point, the chart below shows the annual increase in the Consumer Price Index (CPI) since the year 2000. The index has increased from roughly 170 to about 248, an increase of 47%. So far, so good.
Now for the punchline. The next chart shows the same data over the same timeframe but broken out by components (the things I buy) of the CPI:
Wow. As you can clearly see from the chart, your personal inflation rate is based on what you consume – by choice or otherwise. Healthcare, housing and food and beverage are up well over the average with recreation and apparel significantly below. You shouldn’t need a chart to tell you these things as you live them every day but you may not have noticed – or at least it’s probably not top of mind. This because inflation is often hard to detect in every-day life – small changes in prices over a long period of time leads to the $14 cheeseburger. Sure, you knew that “things are getting more expensive” but $14 for a cheeseburger?! When did that happen?!
I remember making $3 an hour (plus a season pass) working on the golf course when I was in high school and I don’t think I’ve since felt as flush, although this may have as much to do with having kids as with inflation. I also remember 3 burgers for a dollar at the A&W (google it) but now I’m just another person of inflated age talking about the good old days.
Bottom line to this exercise: a little inflation can be a good thing for the economy; a lot of inflation is a very bad thing.