What is Inflation?

by Brian Dolan

What is it?

Inflation is the measure of the rate of change in prices of goods and services. When inflation is positive, prices are generally going up, and purchasing power is declining. For instance, if inflation is +3% per year, a candy bar that costs $1 today will cost $1.03 next year. When the rate of inflation is positive, but declining, say from +1.5% to +1.3% per year, it’s referred to as ‘disinflation.’ When the rate of inflation is negative, meaning prices are actually declining, it’s called ‘deflation.’

Inflation is monitored through economic data reports like the CPI (Consumer Price Index), which measures the price of a basket of goods and services. Inflation is typically reported on a monthly basis (e.g. ‘CPI increased +0.1% from the prior month, or month-over-month (MoM)’) and as a yearly rate (e.g. ‘CPI was up +2.3% from a year earlier, or year-over-year (YoY)’.) In the US, the Federal Reserve pays close attention to another basket of goods and services called the PCE (Personal Consumption Expenditure), which is a more frequently updated basket of goods and services.

Why is it important?

Inflation is important for two main reasons:

  • Inflation eats away at investment returns. If you made an investment and it gained +5% in one year, and the rate of inflation was +2%, your inflation-adjusted return, or ‘real’ return, would only be +3% (5% ‘nominal’ return minus 2% inflation=+3% ‘real’ return).
  • Inflation is a key driver of monetary policy (how central banks set interest rates) and market levels of interest rates, which in turn affect overall economic performance and investment strategies. Higher inflation will tend to see interest rates move higher, potentially reducing borrowing and spending and putting a drag on an economy.

What do I do with it?

There’s not much anyone can do about inflation except to understand it and monitor it. Some investors get carried away worrying about inflation. In reality, a little bit of inflation (2-3%/year) is considered normal and even healthy—it can be a sign of a growing economy. Conversely, too low inflation or outright deflation (declining prices) can be a problem for growth, as consumers and businesses delay purchases now in anticipation of lower prices ahead. Inflation can become a problem when it’s too high for too long, causing uncertainty for businesses, consumers and investors. Major central banks, such as the Federal Reserve in the US or the ECB in the Eurozone, typically aim to keep inflation around +2% per year.

Inflation comes from two main sources:

  • ‘Demand-pull inflation’ is when too much money is chasing too few goods, sending prices higher. Typical in a growing economy, demand-pull inflation needs to be viewed in the context of wages. If wages are rising around the rate of inflation, then the economy can likely continue to expand. If wage increases are falling short of inflation rates, then consumers are falling behind and may undermine economic growth.
  • ‘Cost-push inflation’ comes from the rising costs for businesses to make their products. Higher costs can come from wages, taxes, regulations, and higher raw material inputs (Commodities). Sometimes cost-push inflation is a temporary phenomenon, caused by a drought or an oil price spike on Mid-East tensions, for example. For that reason, central bankers mostly focus on a ‘core’ inflation gauge that excludes volatile components like food and energy. So even though prices at the pump may be higher, the core-CPI excluding food and energy may tell a different inflation story. Stay focused on the core rate to see how policy makers and markets are most likely to respond and where interest rates may go.

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