Inflation means increasing prices and the cost of living in a specific period. It means the dollar value of money decreases at the same time.
Although the FED has taken a few steps like increasing the interest rate to curb the inflation rate in the US, it still remains significantly higher than its targeted rate of 2%.
What is Inflation?
Inflation is the measure of an increase in the prices of goods and services. It applies to the economy overall and an increase in the price of every item generally.
Put another way, it is the declining purchasing power of money over a specified period. As prices increase, a buyer will be able to purchase less of the same goods than before.
The concept of inflation measures the impact of price changes on goods in an economy and the way it affects the end-consumer.
When prices of goods/services in an economy increase at an extreme pace, it is termed hyperinflation. This scenario occurs when prices increase by more than 50% as compared to the previous period.
You can understand the concept of inflation by remembering that the dollar (or any paper currency) is worthless in itself. The value of a currency is its purchasing power.
In simple words, the value of a dollar is determined by how much it can buy you. For instance, if it’s $1.50 to buy a cup of coffee in September and $2.0 in the next month, it is due to inflation.
Inflation means the prices of goods and services, the general cost of living is increasing in a specific period in a given economy. The dollar you have today will buy you less goods tomorrow.
How Inflation is Measured?
There are different ways to measure inflation around the world. However, the common theme in all these methods is to analyze the prices of consumer goods and services in an economy.
Consumer Price Index (CPI)
The most widely used inflation measure in the US is the CPI prepared by the US Bureau of Labor Statistics (BLS).
The BLS directly collects the data from families and consumers in the market. It includes all major items purchased frequently by retail consumers.
A CPI basket typically includes items for groceries, electricity, fuel, medical, healthcare, transportation, and so on.
The BLS tracks the prices of around 94,000 products and services across the US through its research surveys and other scientific methods.
The CPI for August 2022 was recorded at 8.3% which is higher by 0.1% than the previous month.
Producer Price Index (PPI)
The producer price index (PPI) is a cumulative index of different price indices that measure changes in the selling prices for local producers.
Contrary to the CPI, the PPI measures the change in prices for producers rather than consumers. The BLS tracks changes in the selling prices of different industries including food, construction, travel, financial services, etc.
The indices are broadly combined into goods and services sections then. The current PPI for goods remains -1.2% and 0.4% for services for the month of August 2022.
Formula to Measure Inflation
You can calculate inflation in a few ways.
Inflation Rate = (P2 – P1)/P1 × 100
P2 and P1 are price tags of an item at the current and previous points.
If you know the CPI, then you can use this formula:
Inflation Rate = (Final CPI/Initial CPI) × 100
Inflation can be caused by the increased demand for products by consumers, the availability of supplies and raw materials, and market expectations.
What are the Causes of Inflation?
One of the most common reasons for inflation is an excessive supply of cash in an economy. Most economists agree on this exact cause of inflation worldwide.
Broadly, we can categorize causes of inflation into three categories.
The demand-pull effect occurs when there is an excessive supply of money and consumers tend to demand more goods and services.
When this excessive demand results in diminishing supplies, sellers increase prices. The effect can be applied to individual goods/services and an economy broadly.
The cost-push effect results in inflation when the cost of production of goods/services increases or supply lowers and sellers charge more for the same.
The cost can increase due to increases in the prices of raw materials, taxes, costly labor, external events, disruption in supplies, and so on.
The built-in or open inflation means when consumers expect prices to increase further in an economy. As a result, workers generally demand higher wages.
Sellers increase the price due to increased labor costs and an expectation of rising prices in the future.
Why is Inflation So High Right Now?
Although the CPI for the last month stayed at 8.3%, it touched a staggeringly high figure of 9.1% in June this year.
Apart from broader reasons for inflation discussed above, certain events have pushed the inflation rates higher in the US this year.
The recent Russian invasion of Ukraine and Covid-19 resulted in supply chain disruptions worldwide.
Crude oil prices rose significantly and resulted in higher energy costs in the US. Although the hike in gas prices has abated shortly, it is unlikely to reduce to normal levels anytime sooner.
Strong Consumer Demand
Despite staggeringly higher inflation rates and a looming recession, the consumer demand in the US remains strong.
Many companies shifted to remote working which helped control the unemployment rates in the US. The resulting strong purchasing power meant a strong consumer demand.
Government Relief Packages
US government’s unabated stimulus packages and tax relief programs meant consumers had more money during and after the Covid-19 hardships.
It further resulted in consumers believing they had more money and the real impact of inflation is yet to be felt by consumers.
Slower Response from the FED
The FED has increased interest rates in recent months a few times. However, it was slow to react and couldn’t take corrective measures earlier such as releasing controlled stimulus packages after Covid-19.
When you money is kept in cash or on your bank account, inflation practically “burns it away”. When inflation is high, the money you have today will be worth less (can buy less goods & services) in a few months than it could buy today.
How Can Inflation be Managed?
The Federal Open Markets Committee (FOMC) targets an inflation rate of 2% in the US. The FED takes several steps to keep inflation around this rate.
First, the FED increases interest rates to curb inflation. It makes lending difficult and consumers pay more interest on credit card purchases. In turn, that reduces the demand for consumer goods and results in lower inflation.
Second, the FED controls the money supply by increasing the yield on bonds or issuing new ones. It reduces the money supply in the market and curbs the inflation rate.
Finally, the FED often increases the reserve requirement from banks. It means banks need to deposit more cash with the FED and less to lend to consumers.
What Can You Do About Inflation?
There is little you can do as an individual to control inflation. It is an inevitable economic phenomenon. However, you can take certain measures to lower the impact of inflation on your income and lifestyle.
- Invest in stocks to beat inflation as stock prices naturally hedge against inflation rates.
- Invest in specialized inflation-protected securities like Treasury Inflation-Protected Securities (TIPS).
- Depending on your needs, you can invest in bonds as they provide a lower rate of return as compared to stocks but are protected against inflation.
- Invest in the real estate sector either through property purchase or REIT depending on your investment availability.
- You can also invest in alternative investments including oil, gold, and other commodities. However, this method is less effective for protection against inflation.