Inflation is a sustained increase in the average price of all goods and services produced in an economy. Money loses purchasing power during inflationary periods since each unit of currency buys progressively fewer goods.
Suppose the overall price level increased by 3% during the past 12 months. If a "typical urban household" spent $3,000.00 during the first month for all household expenses, then they must budget $3,090.00 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may have even declined, but overall they must budget about $90 more per month now. If their income after taxes does not increase by that amount, they must save less, substitute less expensive items, forgo some items, or incur debt.
Inflation is often reported as a percent change in the overall price level between two periods as measured by a price index. This chart shows December to December changes over the past 53 years as measured by the Consumer Price Index (CPI), a popular measure of inflation in the U.S.. Notice that the rate of inflation varied considerably during the 1970s and into the early 1980s but has been relatively stable recently.
The chart above shows changes in the rate of inflation, not changes in actual prices. A downward-trending line above zero means that prices are still increasing, just at a lower rate. This is sometimes called disinflation but it is inflation nevertheless. When the rate falls below zero, as it did briefly in 1954, average prices actually are falling (deflation). While lower prices may seem ideal at first from a consumer's point of view, deflation leads to rising unemployment and falling production, a situation from which it is extremely difficult to recover. An inflation rate of 1 - 2.5% currently seems to be acceptable by many economists.
Since the inflation rate is a national average of all prices, it may differ considerably from the rate experienced by any one particular household. Each household will have different types and quantities of items in their "market basket" and therefor may experience the effects of inflation differently.
The next chart shows how the effects of sustained inflation accumulate over the years. It contains the CPI index values for December of each year. An index value of 180 means that prices have increased 80% measured from a base of 100. From the index values, it is possible to calculate that a basket of goods and services that cost $3,000 at the end of 1992 will cost $3,897.00 at the end of 2003. Our hypothetical household cannot "wait out" inflation hoping that average prices will return to former levels. They must insure that their income and the interest from their investments keep pace with long-term inflation or they will become relatively poorer.
Causes Of Inflation
Long term inflation occurs when the money supply (currency and check writing deposits) grows at a faster rate than the output of goods and services. When there is more money available than is needed to accommodate normal growth in output, consumers and businesses want to purchase more goods and services than can be produced with current resources (labor, materials, and manufacturing facilities) causing upward pressure on prices. This is often described as "too much money chasing too few goods."
Over a shorter term, inflation can result from various shocks to the economy. Food and energy price shocks are common examples of this in the U.S. The price of a critical commodity such as fuel may rise suddenly and sharply relative to other prices. Since the market does not have time to adjust other prices downward in response, a short-term increase in overall prices occurs. The rate of inflation is sometimes reported with food and energy omitted so the long-term, underlying (or "core") inflation rate is revealed.
Governments need to control high levels of unpredictable inflation since it can severely disrupt the economy, cause uncertainty in financial decisions, and redistribute wealth unevenly. The tools they have available include: monetary policy (increase or decrease the money supply), fiscal policy (change the amount of taxes and governmental spending), and various controls on prices, tariffs, and monopolies. Many nations (including the U.S.) choose monetary policy as their primary tool since it has proven to be very effective, it is less disruptive to market operations, and it is easier and quicker to implement since adjusting the money supply does not require legislative approval as would, for instance, changing the tax structure.
Monetary policy is almost always carried out by a government-controlled central bank that is usually somewhat insulated from political pressure. It is given the responsibility of maintaining an orderly market and juggling the sometimes conflicting goals of steady growth, low unemployment, and low inflation. The governments of some nations require the central bank to maintain a low, positive rate of inflation (usually well under 3%) as the over-riding goal of their monetary policy.2, 4 They must keep the money supply at a level that accommodates steady growth in goods and services, but is not so high as to cause excessive inflation or so low that deflation (an overall decrease in prices) results.
The Federal Reserve System ("Fed"), the central bank of the U.S., does not publicly target a goal for the inflation rate. Instead, they announce goals for the Federal Funds Rate, the interest rate at which banks lend their excess reserves to one another. When the Fed wants to increase the money supply and thereby stimulate the economy, they publicly announce that they intend to lower the Fed Fund Rate. They then buy Treasury securites on the open market which, through a complicated combination of market transactions and federal banking regulations, will increase the amount of loans that private banks can make to consumers and businesses. As banks compete for customers for these new loans, short term interest rates will tend to fall toward the Fed Fund goal. With credit readily available at low interest, comsumers will tend to take out more loans for high-end goods such as homes and cars, and businesses will invest more in facilities and employ more workers to meet the demand. The increase in money supply is essentially borrowed into existance through the private banking system.
If the demand becomes greater then the current workforce and manufacturing facilities can produce at their natural growth limits, inflation will generally occur. The Fed can reduce economic activity by announcing a higher goal for the Fed Fund Rate and then selling Treasury securities to shrink the money supply, raise rates, and thereby ward off inflation. Although the Fed does not publicly state an inflation goal as part of their policy, they have kept prices reasonably stable since about 1996 as shown in Figure 1.
The three most widely used measures of inflation in the U.S. are:
The CPI, which tracks the total cost of a market basket of retail goods and services, is the one most often reported by the media. It is further divided into versions that represent all urban consumers (CPI-U), all urban wage earners (CPI-W), and a new chained version (C-CPI).
The CPI-U tracks the purchasing patterns of urban residents comprising about 87% of the total U.S. population. Rural residents, armed forces personnel, and people in institutions are excluded from it. The BLS periodically selects households within this group and asks them to maintain detailed diaries of their expenditures. From these, the BLS constructs a weighted market basket of goods and services containing thousands of specific items that represent the quantity and type of goods purchased by an average urban household. For example, all housing items were recently weighted at about 42% and all types of food and beverages at about 15%. Then, each month, BLS personnel canvas retail establishments across the nation to update the prices of items in the basket and to calculate its current total cost.
All this activity results in a single index number each month that represents the current price of the basket relative to a base index of 100. The current base index was calculated by setting the average price level of the basket during the reference period of 1982-1984 equal to 100. An index number of 180 means prices have increased 80% from the base index. An index of 40 means prices have declined by 60% from the base index.
The percent change in the CPI between any two periods can be calculated by:
(period2 - period1) / period1 * 100
Figure 2 shows that the price index for December 1992 was 142.30 and the index for December 2003 was 184.90. The percent change in the CPI is ((184.90 - 142.30)/142.30) * 100 = 29.9%. Although prices fluctuated considerably between those dates, the end result was about a 30% change. A market basket that cost $3000 at the end of 1992 cost $3,897.00 (1.299 * 3000) at the end of 2003.
Some believe that the CPI-U generally tends to overstate inflation 3 . The contents and weights assigned to the market basket remain constant over many reporting periods. If the price of a particular item in the basket increases significantly, households may very well substitute less expensive alternatives. However, the CPI-U will continue to price the contents of the original basket as though consumers had no other choices. The BLS have adjusted their methods to partly compensate for substitution, but it has not been completely eliminated. Even a small difference can have a profound effect on the economy since many large contracts are adjusted for inflation by this index. The Fed has begun to use the newer Chained CPI-U (C-CPI-U) in some reports since they feel it states inflation more accurately.
Effects On Time Value Of MoneyPrice Inflation greatly effects time value of money (TVM). It is a major component of interest rates which are at the heart of all TVM calculations. Actual or anticipated changes in the inflation rate cause corresponding changes in interest rates. Lenders know that inflation will erode the value of their money over the term of the loan so they increase the interest rate to compensate for that loss. Figure 2 showed that inflation has been nearly continuous in the U.S. since shortly after World War II. As you can see, long-term loans made at the real rate of interest without an inflation premium would have actually produced negative returns due to the declining purchasing power of the dollar.
An estimate of the inflation premium contained in interest rates can be seen by comparing two risk-free securities with the same maturity date, one with a fixed rate and the other with a rate indexed for inflation. The Fed strongly influences short term interest rates with their monetary policy. However, longer term rates are set by the market and reflect an inflation rate which is its current best guess.
Although it may not be a perfect indicator, the yield of a 10 year, fixed-rate U.S.Treasury note when compared with the rate of a Treasury Inflation Protected Security (TIPS) of the same maturity at least shows that some amount of inflation premium certainly does exist. For example, the Fed Funds rate was recently at 1% and the year-to-year percent change in the CPI (current inflation rate) was 2.3%. At the same time, the anual yield of the fixed-rate note was 4.75% while the TIPS note was at 2%. This would indicate that the market currently expects an average annual inflation rate of around 2.75% (4.75% - 2%) over the ten year period and have added that inflation premium to the fixed-rate, non inflation protected note.
1. US Bureau of Labor Statistics. "Frequently Asked Questions"; http://www.bls.gov/cpi/cpifaq.htm (23 Feb. 2004)
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