What is Inflation?

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Inflation is the rise in the price of goods and services over time. Inflation can impact governments and the little things in the life of ordinary people. If inflation rises too fast it knocks down the value of the currency and can lead to a recession.

The Federal Reserve has an ideal inflation target of 2%. In practical terms, let’s assume one goes to the gas station and pays $2.75 a gallon of gas, next year you can expect to pay $2.81 if the inflation rate remains at 2%.

It’s not easy to measure inflation when there are so many different products and services in an economy the size of the United States. The most relied upon inflation statistic is the Consumer Price Index, called the CPI, and is published on a monthly basis by the Bureau of Labor Statistics. The CPI measures retail prices of goods and services in the country, with more than 80,000 items in the basket, from hundreds of categories. Monthly changes in the CPI represent the rate of inflation for the consumer. The CPI is also available by size of city, by region of the country, for cross-classifications of regions and population-size classes, and for many metropolitan areas.

The other measurement relied upon by analysts is Personal Consumption Expenditures (PCE). The PCE Price Index looks at the changing prices of goods and services purchased by consumers in the U.S. but is constructed differently than the CPI, resulting in different inflation rates.

The PCE price index captures inflation (or deflation) across a wide range of consumer expenses and behavior. For example, if the price of chicken spikes higher, consumer may buy less chicken and more fish.

A variation of the PCE price Index, excludes food and energy. The core index makes it easier to see the underlying inflation trend by excluding those two categories that tend to have dramatic swings more often than other prices. The core PCE price Index is watched closely by the Federal Reserve which sets interest rates in the U.S.

Deflation is the opposite of inflation and occurs when asset and consumer prices fall over time. While that may seem like a good thing in the short run for an economy, widespread deflation can signal a long term drop in demand and can trigger a recession. When a recession hits an economy it generally leads to declining wages, job loss, and a decline in investment portfolios.

The CPI will not measure investment portfolio losses, or the collapse of home price sales, or rents for the consumer, which is why the housing collapse of 2006 went virtually unnoticed. Had asset deflation been the focus, the Federal Reserve may have raised interest rates sooner to prevent the housing bubble.

Deflation slows economic growth, as prices fall, people put off purchases hoping to get a better deal tomorrow, which in turn puts pressure on manufacturers to constantly lower prices and develop new products. Massive deflation turned the 1929 recession into the Great Depression.

Both inflation and deflation economic conditions are difficult to combat once it takes hold in an economy. During a spike in inflation the Federal Reserve can raise interest rates to slow the economy. During deflation the Fed has fewer tools because interest rates can only be lowered to zero, making deflation the most feared economic condition.

Stagflation is a combination of stagnant economic growth, high unemployment, and high inflation. It’s an unnatural situation because inflation is not supposed to occur in a weak economy. Generally stagflation appears when the Federal Reserve increases the money supply, it can also appear when a Central Banks policies create credit. Both increase the money supply and create inflation. Stagflation occurred in the U.S. in the 1970’s when the government manipulated its currency to spur economic growth, while implementing wage price controls. Then gas prices went through the roof when OPEC unexpectedly raised prices significantly. The combination brought stagflation to the U.S. and interest rates getting as high as 20% to combat stifling economic conditions.