Sixty or 70 years ago, it was possible to buy a car for less than $1,000 and an average house for roughly $5,000. In today’s world, this is hard for us to imagine.
Although it’s mostly common knowledge that prices go up over time, many people don’t fully understand the forces behind inflation nor the resulting implications.
What is inflation?
Inflation occurs when the prices of goods and services increase over time. You can also think of it in terms of a decrease in the value of money. In other words, it takes more dollars (or Euro, or Yen) to purchase the same good and service as it did in the past.
The Federal Reserve doesn’t measure inflation by an increase in the cost of one product or service. Rather, inflation is a general increase in the overall price level of the goods and services in the economy. They do this by monitoring several different price indexes, including the Producer Price Index and the Consumer Price Index (CPI).
You can think of these indexes like large surveys. To calculate the CPI, for example, the U.S. Bureau of Labor Statistics contacts thousands of retailers every month to gather price information on roughly 80,000 items. These items represent a scientifically selected sample of the prices paid by consumers for the goods and services purchased.
What is an acceptable level of inflation?
The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is an “acceptable” level of inflation.
Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.
What happens when there is a high inflation rate?
In the late 1970s, the inflation rate surged to a double digit level, resulting in higher food and product prices, while the currency weakened. Let’s take a look at exactly what happens when the inflation rate rises:
- Costs go up – you will have to pay more for products and services.
- Loans become more expensive – most loan rates will go up, meaning you will have to pay more for your car loan or mortgage.
- Returns from investments will decrease – when adjusted for inflation, fixed bank deposits and mutual fund returns typically yield low returns.
- Taxes may increase.
- The value of your total portfolio will likely decrease. Since inflation challenges the growth of companies, stocks are typically negatively impacted by inflation.
What happens when there is a low inflation rate?
When there is a relatively low inflation rate, it’s easier to make long-range plans for your finances because you can be confident the purchasing power of your money will remain steady. There are other implications:
- The cost of borrowing will go down – this encourages households to buy durable goods, such as houses and autos. It also encourages businesses to invest in order to improve productivity so that they can stay competitive and prosper without steadily having to raise prices.
- Sustained low inflation is self-reinforcing. When the public is confident inflation is under long-term control, they do not react as quickly to short-term price pressures by seeking to raise prices and wages. This helps to keep inflation low.
However, a very low inflation rate increases the likelihood of falling into deflations, which means prices and often also wages are falling, which is a sign of a very weak economy.
Just like any other money management issue, the impact of inflation depends on your personal situation. Become cognizant of the nation’s inflation rate so you can adjust your money management strategies accordingly.