What is Inflation?

What is Inflation?:

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Inflation is defined as a sustained increase in the general level of prices for goods and services in a country and is measured as an annual percentage change. Under conditions of inflation, the prices of things rise over time. Put differently, as inflation rises, every dollar you own buys a smaller percentage of a good or service. When prices rise, and alternatively when the value of money falls you have inflation.

The value of a dollar (or any unit of money) is expressed in terms of its purchasing power, which is the amount of real, tangible goods or actual services that money can buy at a moment in time. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar does not go as far as it did in the past. This why a pack of gum cost just $0.05 in the 1940’s – the price has risen, or from a different perspective, the value of the dollar has declined. In recent years, most developed countries have attempted to sustain an inflation rate of 2-3% by using monetary policy tools put to use by central banks. This general form of monetary policy is known as inflation targeting.

Causes of Inflation

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There is no single theory for the cause of inflation that is universally agreed upon by economists and academics, but there are a few hypotheses that are commonly held.

Demand-Pull Inflation – Inflation is caused by the overall increase in demand for goods and services, which bids up their prices. This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in rapidly growing economies. This theory is often promoted by the Keynesian school of economics.

Cost-Push Inflation – Inflation is caused when companies' costs of production go up. When this happens, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of natural resources or imports.

Monetary Inflation – Inflation is caused by an oversupply of money in the economy. Just like any other commodity, the prices of things are determined by their supply and demand. If there is too much supply, the price of that thing goes down. If that thing is money, and too much supply of money makes its value go down, the result is that the prices of everything else priced in dollars must go up! This theory is often promoted by the “Monetarist” school of economics.

Costs of Inflation

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Inflation affects different people in different ways, with some benefiting from its effects at the expense of some who lose out. It also depends on whether changes to the rate of inflation are anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the impact isn't necessarily as severe. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as prices go up.

Here is a brief account of the typical winners and losers from inflation:

• Creditors (lenders) lose and debtors (borrowers) gain under inflation. For example, suppose a bank issues you a 30-year mortgage to buy a house at a fixed interest rate of 5% per year, costing $1,000 per month. As inflation rises, the “cost” of that $1,000 per month decreases, which benefits the homeowner, especially if the rate of inflation exceeds the interest rate on the loan.
• Inflation hurts savers since a dollar saved will be worth less in the future. Unless the money is saved in an account that pays an interest rate at or above the rate of inflation, the purchasing power of savings will erode. This phenomenon is sometimes called "cash-drag."
• Workers with fixed salaries or contracts that do not adjust with inflation will be hurt as the buying power of their incomes stay the same relative to rising prices.
• Similarly, people living off a fixed-income, such as those below the poverty line, retirees or annuitants, see a decline in their purchasing power and, consequently, their standard of living.
• Landlords benefit, if they have a fixed mortgage (or no mortgage) as they are able to raise the rent more each year.
• Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
• The entire economy must absorb repricing costs (menu costs) as price lists, labels, menus and more have to be updated.
• If the domestic inflation rate is greater than that of other countries, domestic products become less competitive.

Different forms of Inflation

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There are several variations on the theme of inflation.

Deflation is when the general level of prices are falling. It is the opposite effect of inflation. Deflation tends to occur more rarely and for shorter periods of time than inflation. Deflation occurs typically during times of recession or economic crisis and can lead to deep economic crises including depression. The reason for this is the so-called deflationary spiral: when prices are going down, why would you spend your money today, when each dollar will be more valuable tomorrow? And why spend tomorrow when each dollar can buy more the day after? The result is that people stop spending and hoard their money in anticipation of prices falling even further. If money is being hoarded, it isn’t being spent, so business profits collapse and people are laid off. Increasing unemployment leaves the economy with even less spending, and the spiral continues.

Disinflation is a condition where inflation is still positive, but the rate of inflation is decreasing – for example from +3% to +2%.

Hyperinflation is unusually rapid inflation, typically more than 50% in a single month. In extreme cases, this inflation gone awry can lead to the breakdown of a nation's monetary system or even its economy. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month! Likewise, in Zimbabwe, hyperinflation led to Z$100 trillion bills being printed that were worth only a few U.S. dollars. Hyperinflations have also famously occurred in Hungary and Argentina in the 20^th century.

Stagflation is the rare combination of high unemployment and economic stagnation along with high rates of inflation. This happened in industrialized countries during the 1970s, when a rocky economy was confronted with OPEC raising oil prices resulting in a demand shock for oil. This sent the price of oil – and all of the products and services that use oil as an input – higher, even as the economy slackened.

People often complain when prices go up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages. A modest inflation is a sign that an economy is growing. In some situations, little inflation can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad – it depends on the overall economy as well as your personal situation.

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How is Inflation Measured?

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Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year. 

In North America, there are two main price indexes that measure inflation:

• Consumer Price Index (CPI) - A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics.
• Producer Price Indexes (PPI) - A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.

You can think of price indexes as large surveys. Each month, the U.S. Bureau of Labor Statistics contacts thousands of retail stores, service establishments, rental units and doctors' offices to obtain price information on thousands of items used to track and measure price changes in the CPI. They record the prices of about 80,000 items each month, which represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased.

In the long run, the various PPIs and the CPI show a similar rate of inflation. This is not the case in the short run, as PPIs often increase before the CPI. In general, investors follow the CPI more than the PPIs.

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How does Inflation affect interest rates?

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Inflation and interest rates are often mentioned in the same breath, and this is because the two are closely related. In the United States, baseline interest rates are set by the central bank, the Federal Reserve Bank also known as the Fed. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed's decision, because the Fed, as well as other major central banks, have a specific interest rate target in mind for the economy to achieve, usually 2-3% annually. This is known as inflation targeting. If inflation is the cost of saving money, interest rates are the cost of borrowing it.

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Interest rates directly affect lending and borrowing because higher interest rates make servicing loans more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices and a good level growth. As interest rates drop, consumer spending increases, and this in turn stimulates economic growth which can spur inflation. The central bank also wants to keep growth in check, since excessive economic growth can in fact be quite detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, resulting in the problems we mentioned earlier. At the other extreme, an economy with no inflation has essentially stagnated and can experience a deflationary spiral. The right level of economic growth, and thus inflation, is somewhere in the middle. It's the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.

Inflation targeting originated as an official policy in the late 1970’s with the Reserve Bank of New Zealand. The practice has since spread throughout much of the world. However, inflation targeting has come under fire over the past few years. First, despite inflation targeting, the rate of inflation has remained below its target in the U.S. for nearly every year since the Great Recession in 2008. Moreover, in Europe, they have even experienced deflation a few times over the past decade. A larger point is that the 2-3% inflation target, while it seems reasonable, is actually an arbitrary number with little to no empirical evidence that it is a valid level to target in the first place.

Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed's decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown.

Inflation is also related closely to unemployment. The Phillips Curve relates the inverse relationship between the two. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been challenged empirically due to the occurrence of stagflation in the 1970’s when there were high levels of both inflation and unemployment. Economists have responded by allowing for many different Phillips Curves to exist, or by amending the relationship between inflation and unemployment to changes in the rates of inflation and unemployment.

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Inflation and Investing

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Inflation is also a concern to investors, since changes in inflation and interest rates affect various asset types in different ways. This is an especially important issue for people living on a fixed income, such as retirees.

The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night since historically stocks have been quite good hedges against inflation. Over the long run, a company's revenue and earnings should increase at approximately the same pace as inflation, so the prices of stocks should rise along with the general prices of consumer and producer goods. The exception to this is stagflation; the combination of a bad economy with an increase in costs is bad for stocks. Not all companies fare the same with inflation- for example a company with a lot of cash will see the value of that cash decrease with increases in inflation.

The more general problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the apparent growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory (for example LIFO vs. FIFO).

Fixed-income (i.e. bond) investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return the same as $100 a year ago? Of course not. Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your net return is really 6%. Remember that inflation benefits borrowers at the expense of lenders: owning a bond is equivalent to being a lender.

This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%). The terms “real” and “nominal” are also used when talking about changes in GDP, where real GDP accounts for the effects of inflation. Inflation is also accounted for when measuring things in constant dollars – for example, measuring wages in constant 2012 dollars takes out the effects of inflation. As an investor, you must look at your real rate of return. Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.

There are a class of bonds that do offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other government issued bond, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation (the actual calculation of price changes and yield on TIPS given changes in inflation can be complicated). TIPS seem like a smart idea, but they have underperformed similar assets over the past decade. Inflation has been so low in recent years that it hasn't been much of an issue and they’ve offered an extremely low rate of return.

Commodities can benefit or lose out to inflation depending on the specific type of commodity. Gold and other precious metals have long been considered a good hedge against inflation, rising in value as the dollar falls. On the other hand, consumable or perishable commodities such as wheat, livestock, or oil tend to do poorly for investors and are not effective hedges against inflation.

Conclusion

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After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.

Some points to remember:

• Inflation is a sustained increase in the general level of prices for goods and services.
• When inflation goes up, there is a decline in the value, or purchasing power of money.
• Variations on inflation include disinflation​, deflation, hyperinflation and stagflation.
• Theories as to the cause of inflation are up for debate. Some common theories include demand-pull inflation, cost-push inflation, and monetary inflation.
• When there is unanticipated inflation, creditors lose, people on a fixed-income lose, menu costs go up, uncertainty reduces spending and exporters aren't as competitive.
• Lack of inflation (or deflation) is not necessarily a good thing and can lead to destabilizing deflationary spirals.
• Inflation is measured with a price index.
• The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes. The GDP- and Price-deflator are also used.
• Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates since it uses inflation-targeting as a policy.
• In the long term, stocks and precious metals are good protection against inflation.
• Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
• Inflation-indexed securities offer protection against inflation but offer low returns.

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