Financial Literacy

What is Inflation and Why Should You Care?

Do you hold your breath whenever the Fed announces that they’re going to raise or lower the interest rate? What about when ABC News breaks in with the latest Dow Jones reports? And do you know the difference between trending bear or bull markets?

If you’re like the majority of Americans, race notwithstanding, you probably have other things on your mind.

Undoubtedly, you’ve observed that prices for some essentials go up year after year: college tuition, prescription drugs and the rent for an apartment. Prices of other things, like basic laptop computers, televisions and not-so-fashionable apparel have tended to fall over time.

The Labor Department’s consumer price index measures the overall change in the price of goods and services based on an average person’s budget. That assumes roughly 33 percent spent on housing, 13 percent on food, 9 percent on health care, 8 percent on energy — electricity, gas and fuel for your car — you get the point.

Inflation for Beginners

Inflation is a general rise in the price of goods and services that erodes the value, or purchasing power, of the dollars in your wallet and bank account. The inflation rate is the percentage increase in prices over 12 months. The 1.9 percent rise in the consumer price index in 2018 essentially meant that $1 at the start of 2018 was worth 98.1 cents at the start of 2019.

Sometimes prices rise because demand exceeds supply, allowing the seller to raise prices — and profits.

Producers also may increase prices when they’re faced with cost increases of their own. Wages are another major business cost and can contribute to inflation when they are increasing. Wages recently have risen both because of state and local minimum wage hikes and because employers have to pay more to retain and attract quality workers at a time of low unemployment.

But companies often try to limit the cost increases they pass on to customers by finding ways to make their operations more efficient and their workers more productive. Fast-food companies and their franchisees have tried to find efficiencies via mobile orders. A price increase will generally dampen demand somewhat. But when a price hike nevertheless boosts revenue, companies are said to have pricing power. In robust economic times, when wages are rising nicely and people have more cash at their disposal, more companies are likely to have pricing power. That’s why the inflation rate tends to be cyclical, rising when the economy is zipping along, and slackening when consumers become less optimistic and more tightfisted.

How Does Inflation Affect Interest Rates?

The job of the Federal Reserve is to balance low inflation and maximum sustainable employment. In other words, the U.S. central bank is supposed to keep the jobless rate as low as possible without setting off an upsurge in inflation. The Fed has officially adopted a 2 percent annual inflation target, and it primarily uses interest rates to achieve its goal.

When the Fed’s key interest rate — the rate for overnight bank loans — is low, banks can offer cheaper loans to businesses and consumers, helping the economy grow. By hiking its key rate, as it did nine times from 2015 through 2018, the Fed restrains growth by raising borrowing costs.

Why would the Fed want to slow growth? After all, inflation has been tame for the past couple of decades, and most people expect it to remain that way. Mainly, policymakers worry about the economy overheating.

Inflation is just one of the symptoms that reveal excesses building up in the economy. Such excesses can turn a boom into a recession, like happened with the Dot-Com and housing bubbles.

A little inflation is seen as healthy, but its costs begin to mount as inflation heads higher.

When the value of money erodes at a faster pace, lenders are getting paid back in cheaper dollars. So, they must charge higher interest rates to compensate their risk. Retirees and those close to retirement who have much of their savings in bonds that aren’t protected for inflation are at risk of seeing the value of their savings shrink when inflation gathers steam.

But the Fed worries even more about deflation, an outright decline in prices. Falling prices make it harder for debtors to repay loans.

However, the consumer price index is the best-known inflation measure. But the Fed prefers a somewhat different measure of prices, the Commerce Department’s personal consumption expenditures price index. The Fed’s inflation target also focuses on core prices, excluding volatile food and energy costs. In addition to prices paid directly by consumers, the PCE price index also factors in bills that are paid on behalf of consumers, such as government reimbursement of hospital bills.

The CPI and PCE both measure prices on the consumer level. The Labor Department’s producer price index tracks wholesale inflation based on prices paid by one business to another.

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