Businessman calculating impacts of inflation on finances.

What Is Inflation And How Much Do We Need To Worry About It?

Carla Ayers6-Minute Read
August 20, 2021

Are you thinking about the economic future of America while we’re still in a global pandemic? It’s a tough subject to wrap your head around. You’ve likely heard or read headlines about inflationary pressures caused by the pandemic. Many are questioning whether we are headed for a sustained bout of inflation.

Here we’ll discuss how the current market conditions are ripe for inflation and what that could mean for the U.S. economy and the average household budget.

What Is Inflation?

Inflation can be described simply as a currency’s loss of buying power. Some baby boomers might remember the inflation rates of the 1970s skyrocketing as high as 20%. None of the generations that have come after have experienced true inflation. One dollar in the 1900s has the same buying power today of $32.50.

Inflation is tracked through a variety of metrics we will discuss below.

What Does The Inflation Rate Mean?

The inflation rate is a measure of how much the value of the currency in question is decreasing or how much the cost of goods and services is rising.

Say, for example, you’re looking for a good used car. At the beginning of the month, you test drive a very nice $10,000 car. When you go back a few weeks later, the price is $10,500. That car's price inflation rate of 5% would cost you an additional $500 to purchase it in just 1 month’s time.

Is There An Optimal Inflation Rate?

While no one likes to pay more for less, an inflation rate of 2% or below is generally considered optimal. At a 2% inflation rate, most wages can keep up with inflation and consumers do not lose buying power.

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How Is Inflation Measured And Discussed?

When discussing how inflation is measured, there are many terms used. We will explore some of those terms below.

Metrics

Economists consider several metrics when evaluating the threat posed by inflation. The two common measures of inflation in the United States today are the Consumer Price Index (CPI) and the Personal Consumption Expenditures price index (PCE).

The Personal Consumption Expenditures price index (PCE) is released by the Bureau of Economic Analysis (BEA). The BEA collects data and reports the total value of personal consumption expenditures collectively every month.

Durable goods are items you may purchase that have a life expectancy of 3 or more years. Furniture, appliances, vehicles, etc. Nondurable goods are less-costly day-to-day items like clothes, shoes and personal hygiene supplies. The Federal reserve uses the Personal Consumption Expenditures price index to measure inflation and target its economic goals.

The Consumer Price Index (CPI) is released by the Bureau of Labor and Statistics (BLS). BLS collects surveys from several sectors of the population in retail, office, and manufacturing. More than 200 categories of goods and services are reported. Because of the variety of categories, the data gives great insight into everyday American spending. The Social Security Administration uses CPI data to evaluate cost of living adjustments for those receiving social security benefits.

Both CPI and PCE monitor consumer spending and the cost of goods and services over a certain time period to evaluate inflation increase and decrease. Traditionally CPI tends to report higher inflation rates.

Both CPI and PCE have seen a significant jump in inflation throughout the pandemic. At the time of this writing, over the last 12 months the CPI increased to 5.4%, while the PCE rate increased to 4%. It can be alarming to see such an increase, but 2021 had a lot of contributing factors that caused such drastic increases.

Temperature

Economists often describe economies metaphorically as “heating up” or “cooling down.”

An economy that is “heating up” is at a boil, unemployment is low and consumer confidence is high. Inflation increases both because sellers are confident enough to raise prices and because buyers start to feel that if they don’t buy today, they’ll have to pay more later. This mindset drives more confident spending now.

“Cooling down” means the economy is on ice, unemployment is high and consumer confidence is low. Inflation decreases because consumers are not buying unless prices are low enough to overcome their economic insecurities.

How Does Inflation Work?

Inflation is simply supply and demand. Rising prices can cause rising unemployment because people buy less when prices are high.

When unemployment is low, consumer confidence is high and they have discretionary income to spend resulting in more money in the economy.

A rise in unemployment could lead to a recession. But let's not get ahead of ourselves. As we stated before, 2021 had a few contributing factors to these historically high inflation markers.

Temporary Inflation

The main contributing factor in the spike in both CPI and PCE was a major slowdown in production globally. The pandemic disrupted the global supply chain and created huge swells in demand. A simple example is the toilet paper shortage that happened early on in the pandemic.

In the spring of 2020, a lot of paper products became nearly impossible to find on retail shelves. Many buyers struggled to find toilet paper in the store. Some paid exorbitant prices until the supply chain could adjust to new demands and the limitations caused by the pandemic.

Another example of temporary inflation you may be familiar with, is gas prices after Hurricane Katrina. Hurricane Katrina put a halt to oil production in the Gulf of Mexico, leaving the rest of the country struggling to make up for the lost fuel supplies. When and if Southern residents did find fuel, they paid a hefty price for the scarce resource. Gas prices all over the country increased after Hurricane Katrina and have continued to do so over time.

Long Term Inflationary Pressures

Some economists are concerned that short-term inflationary pressures brought on by the pandemic could snowball into long-term inflation because there are additional demand side factors at play: consumers have extra cash from government stimulus programs and there is pent-up demand after months on lockdown.

Inflation incentivizes buyers to purchase immediately, before prices rise further, which can further overheat the economy, until they, too, lose or begin to fear losing their jobs. At this point recessionary, or cooling, pressures take hold of the economy.

It will be some time before economists can collect enough data to understand just how much the coronavirus pandemic has impacted our local, national, and global economy and the true impact on inflation.

What Happens When There Is More Inflation Than Is Considered Optimal?

The last serious bout of inflation in the U.S. occurred in the 1970s and was brought on primarily by an oil embargo that resulted in constantly rising fuel prices. Inflation caused by the rising costs of inputs, in this case fuel, is known as cost-push inflation.

During the 1970s, economists made the important discovery that many of their theories were flawed, and that in order to beat inflation, it was necessary to reduce the amount of money available in the economy by raising interest rates.

How Do Governments Fight Inflation?

There are two main tools that the government uses to fight inflation: monetary policy and fiscal policy.

Monetary Policy

In the U.S., the central bank is known as the Federal Reserve (the Fed). A nation’s central bank generally controls how much money is available in an economy. In the early 1980s, Federal Funds rates approached 20% as the Fed worked to reduce the amount of money in the economy.

There are a few ways the Fed can do this. They can indirectly control interest rates, sell new debt, or even issue bonds at the higher interest rate, which removes money from the economy.

Fiscal Policy

The United States government is the single biggest consumer of goods and services in the world, so when the government cuts back on those purchases, it can cool off an overheating economy fairly well. Governments can also raise taxes to remove money from the economy, but they rarely do so because of the political ramifications associated with raising taxes.

How Does Inflation Affect Households?

Inflation hurts the average American immediately by reducing a consumer’s buying power, followed by their job security. On the other hand, high inflation means that savings and interest-based investments earn more because interest rates rise across the board.

This can be incredibly frustrating for those retirees relying on fixed income and expecting savings and interest-based investments to grow and provide a solid financial outlook for their future.

The Bottom Line: Too Much Inflation Hurts But It Can Be Fleeting

Inflation isn’t all bad. There is a time and a need for inflation in our economy. However, too much can tip our nation into recession.

It’s too soon to say whether the current inflation is here to stay. It’s never too soon to speak with a financial planning professional to inflation-proof your retirement planning to ensure your family’s financial future is bright.

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Carla Ayers

Carla is a Realtor® with a background in commercial and residential property management, leasing  and arts management. She has a Bachelors in Arts Marketing and Masters in Integrated Marketing & Communications from Eastern Michigan University.