Most people don’t have a kind word to say about inflation, and those on fixed incomes hate it. Why? Because it makes everything more expensive; and when you’re living on an income that never rises, your standard of living suffers.
But ask most economists and they’ll tell you that within limits, inflation is a good thing and its opposite ─ deflation ─ is a very bad thing. How can that be?
The broad definition of inflation is a general increase in prices. Deflation is the
opposite ─ a general fall in prices. When we say general, we’re referring to the prices of most goods and services. This is an important distinction because prices of some things move in a different direction from most.
For example, regardless of what’s happening to the price of food or clothing, prices generally fall for new, high-technology items after a number of years. That’s usually because manufacturers achieve economies of scale and are able to pass the associated savings along to consumers, and/or they have invented new, less-expensive ways to make the latest gadget. It also happens when more manufacturers come into the market and compete against established makers on the basis of price.
There can also be regional differences in the prices of some goods. An example is real estate, where prices may be falling in areas that are experiencing a high rate of job losses, while in areas where the job market is booming, housing prices are rising.
Three Measures of Inflation
- The Consumer Price Index (CPI). This is the figure that most Americans think of when they think about inflation. It’s calculated monthly by the Bureau of Labor Statistics, based on the prices of a basket of some 80,000 different goods and services that most consumers buy in markets all across the country. The Bureau of Labor Statistics categorizes those goods and services as:
- Food and beverages (including at-home and restaurant meals)
- Housing (rent of primary residence, owners’ equivalent rent, furniture)
- Clothing (including jewelry)
- Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
- Medical care (prescription drugs, and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
- Recreation (Televisions, toys, pets and pet products, sports equipment, admissions)
- Education and communication (college tuition, postage, telephone services, computer software and accessories)
- Other goods and services (tobacco and smoking products, haircuts, and other personal services)
The CPI also includes sales and excise taxes, utility fees, and highway tolls. It excludes investments like stocks, bonds, and insurance, as well as income and Social Security taxes.
You’ll sometimes hear the expression core inflation. This is a derivation of the CPI that excludes the goods that have very volatile prices, like food and fuel. The idea is to avoid outlying, short-run price changes that mask longer-term trends.
- GDP deflator. Based on changes in Gross Domestic Product (GDP), this is a broader measure than the CPI because it includes every kind of good and service the economy produces and delivers. For example, it includes raw materials and industrial goods, like steel, factory equipment, and investment services. It’s expressed as a percentage that reduces the nominal new price of a good or service to reflect the quantity of goods. The GDP deflator is regarded as a more accurate measure of price trends throughout the entire economy.
- Producer Price Index (PPI). This measures changes in the wholesale prices of goods and services by manufacturers. It’s often looked at as a leading indicator ─ to estimate later changes in the CPI.
How Can Inflation Be a Good Thing?
Inflation is a byproduct of economic growth, which is the means by which the standard of living rises. Think of it this way: prices are a function of supply and demand; if businesses post higher prices for their goods and services and they stick, it’s because demand is willing and able to pay those prices. One of the ways people can afford to pay more is if their incomes are rising, which is what happens when they are working for successful companies. Higher prices are also supported when there is a continually growing number of people with jobs and money to spend.
Inflation can also stimulate growth by making existing debt cheaper. Think of homeowners who stretch their budget to buy the nicest home they can afford. Over time, if the economy grows, so does their income. If they hold a fixed-rate mortgage, their monthly mortgage payment for principal and interest becomes a smaller and smaller percentage of their income. As a result, they have an increasing amount of free cash flow to spend on other goods and services. And that, in turn, causes businesses to hire more people.
The Destructive Power of Deflation
Deflation is a general decline in prices ─ not to be confused with a decreasing rate of inflation ─ and is a destructive economic force. For one thing, it’s a sign that businesses can’t pass along higher costs of production. Second, it results in lower revenue and, if it lasts for several years, cutbacks in production and employment. When people lose their jobs, they spend less, have trouble keeping up with their bills, and even lose their homes.
Third, deflation makes debt more expensive. As incomes and business profits decline, fixed-rate loans become an increasingly larger percentage of cash flow. Banks foreclose on mortgages, increasing the supply of homes and driving down the value of all homes, and some businesses go into bankruptcy. Banks make fewer loans because fewer borrowers qualify. People who still have jobs start paying off debt more aggressively. This further reduces demand for goods and services, and the economy goes into a negative feedback loop, feeding negative growth and higher unemployment.
Deflation is one of the major causes of economic depressions. In the 13 years from 1927 through 1939, the U.S. experienced CPI deflation in eight years, with prices falling 8.9% in 1931, 10.3% in 1932, and 5.0% in 1933. By comparison, during the Great Recession, we experienced only one year of very slight deflation, in 2009, when the CPI fell by 0.4%.
The Inflation Ideal: Low Single Digits
Is there an ideal rate of inflation? Economists suggest that a moderate rate of inflation ─ in the low single digits ─ is optimal for sustained long-term growth. Indeed, the Federal Reserve Bank has said that an inflation rate of 2% to 3% is ideal.
Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.