What causes inflation?
nytimes.com/article/inflation-definition.html
Inflation has become central to the American zeitgeist in 2021 in a way that it hadn’t been for
decades. Google searches are up. Supply chain issues feature into popular Instagram posts.
The satire website The Onion warned in a recent headline that “higher prices may force
Americans to eat reasonable portions on Thanksgiving.”
Even as inflation hits its highest level since 1982 and inserts itself as a topic of popular
discussion, trying to understand it can be a mind-bending task. Some people who have
studied markets and the economy for years often do not know the ins and outs of how
inflation is calculated. Its aftereffects on society — from who wins and who loses to whether it
is good or bad news — are nuanced.
What are your questions about inflation?
Times reporters want to answer your questions about where inflation is likely to go and how
it may affect your life.
Jan. 7, 2022
Here’s a guide to help explain what inflation is, including how it is measured and what it
means for your economic security and savings.
What is inflation?
Inflation is a loss of purchasing power over time: It means your dollar will not go as far
tomorrow as it did today.
Inflation is typically expressed as the annual change in prices for a basket of goods and
services. In the United States, there are two main inflation gauges.
One, the Consumer Price Index or C.P.I., measures the cost of things urban consumers buy
out of pocket. The other, the Personal Consumption Expenditures index, or P.C.E., is
released at more of a lag and measures things people consume, including things they do not
pay for directly — notably health care, which insurance and government benefits help to
cover. The two indexes are also built slightly differently.
The Federal Reserve, America’s central bank and the institution in charge of keeping prices
from increasing too rapidly, targets 2 percent annual increases in the P.C.E. index on average
over time. A little bit of consumer price inflation is generally viewed as desirable, in part
because it gives companies room to adjust to a changing economy — one where labor and
commodities might cost more — without being forced out of business.
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In the short term, high inflation can be the result of a hot economy — one in which people
have a lot of surplus cash or are accessing a lot of credit and want to spend. If consumers are
buying goods and services eagerly enough, businesses may need to raise prices because they
lack adequate supply. Or companies may choose to charge more because they realize they can
raise prices and improve their profits without losing customers.
But inflation can — and often does — rise and fall based on developments that have little to
do with economic conditions. Limited oil production can make gas expensive. Supply chain
problems can keep goods in short supply, pushing up prices.
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The inflationary burst America has experienced this year has been driven partly by quirks
and partly by demand.
On the quirk side, the coronavirus has caused factories to shut down and has clogged
shipping routes, helping to limit the supply of cars and couches and pushing prices higher.
Airfares and rates for hotel rooms have rebounded after dropping in the depths of the
pandemic. Gas prices have also contributed to heady gains recently.
But it is also the case that consumers, who collectively built up big savings thanks to months
in lockdown and repeated government stimulus checks, are spending robustly and their
demand is driving part of inflation. They are continuing to buy even as costs for exercise
equipment or outdoor furniture rise, and they are shouldering increases in rent and home
prices. The indefatigable shopping is helping to keep price increases brisk.
Where is inflation headed and should I be worried?
Officials say they do not yet see evidence that rapid inflation is turning into a permanent
feature of the economic landscape, even as prices rise very quickly: The C.P.I. measure rose
by 6.8 percent and P.C.E. climbed 5.7 percent in November from a year earlier, the fastest
pace since 1982 for both indexes.
There are plenty of reasons to believe that the price burst will fade. Much of the increase this
year owes to shortages of goods — from bicycles to cars and beds — that are likely to
eventually ease as companies figure out how to produce and transport what people want to
buy in a pandemic-altered economy. Many households also have built up savings, in part
because of repeated stimulus payments, but they eventually could exhaust those.
Plus, before the pandemic, aging demographics and high inequality in income and wealth
had combined to drag inflation steadily lower for years as people preferred to save money
instead of spending it, and those basic economic building blocks haven’t changed.
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But there are concerning signs that inflation is becoming stickier, meaning that it might last
rather than fading with time. Rents have picked up sharply as home prices have risen and
would-be buyers have found themselves locked out of ownership. Consumers are slowly
starting to anticipate higher prices, though long-term inflation expectations have yet to jump
drastically higher.
In the longer term, the (sometimes contested) theory goes, high inflation can become
entrenched if workers begin to expect it and can successfully negotiate wage increases to
cover their climbing costs. Companies, facing higher labor bills, may manage to pass the costs
onto consumers — and voilà, you have a situation where pay and prices push one another
steadily upward.
Is inflation bad?
Whether inflation is “bad” depends on the circumstances.
Most everyone agrees that super fast price increases — often called hyperinflation — spell
trouble. They destabilize political systems, turn middle-class workers into paupers overnight,
and make it impossible for businesses to plan. Weimar Germany, where hyperinflation
helped to usher Adolf Hitler into power, is often cited as a case in point.
Moderate price gains, even ones a bit above the Fed’s official goal, are a topic of more-serious
debate. Slightly higher inflation can be good for people who owe money at fixed interest
rates. If I sell coconuts for $1 and owe my bank $200 today, but next year I am suddenly able
to charge $1.05 for my coconuts, my debt becomes easier for me to pay back: Now I only have
to sell a little bit over 190 coconuts plus interest.
But inflation can be tough for lenders. The bank to whom I owe my $200 is obviously not
happy to get 190 coconuts worth of money instead of 200 coconuts worth. While politicians
and the public rarely cry for bankers, the same is true for people with savings that bear low
interest: Their holdings will not go as far. Inflation can be especially tough for people on fixed
incomes, like students and many retirees.
For workers taking home paychecks, whether inflation is a good or bad thing hinges on what
happens with wages. If a worker’s pay goes up faster than prices increase, they can still find
themselves better off in a high-inflation environment.
Wages are growing quickly right now, especially for lower earners, but some measures
suggest the growth is not keeping pace with inflation as it picks up steeply. Still, many
households are also receiving transfers from the government — including an expanded Child
Tax Credit — which could keep some families’ financial situations from deteriorating.
How does inflation affect the poor?
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High or unpredictable inflation that isn’t outmatched by wage gains can be especially hard to
shoulder for poor people, simply because they have less wiggle room.
Poor households spend a bigger chunk of their budgets on necessities — food, housing and
especially gas, which is often a contributor to bouts of high inflation — and less on
discretionary expenditures. If rich households face high inflation and their wages do not keep
up, they may have to cut back on vacations or dining out. A poor family may be forced to cut
back on essentials, like food.
“For lower income households, price increases eat up more of their budget,” said Laura
Rosner-Warburton, a senior economist at MacroPolicy Perspectives, pointing out that some
research suggests that poor people may even end up paying comparatively more for the same
products. That may be partly because they lack the free cash to take advantage of temporary
discounts.
Around the world, poor people historically have reported greater concern around inflation,
and that is also the case in the United States in the current episode.
How does inflation affect the stock market?
Really high inflation typically spells trouble for stocks, said Aswath Damodaran, who teaches
corporate finance and valuation at New York University’s Stern School of Business. Financial
assets in general have historically fared badly during inflation booms, Mr. Damodaran said,
while real assets like houses have better held their value.
The reason is simple.
“You need to make higher returns to break even,” he explained. While it might have been
attractive to invest money for a 3 percent annual payback before an inflationary burst, once
inflation has taken off to 4 percent, your investment would actually be declining in terms of
real-world purchasing power.
Plus, inflation can be tough on the underlying business. Companies that lack pricing power —
meaning that they cannot easily pass costs on to customers — suffer the worst, because they
are forced to absorb input cost increases by taking a hit to their profit margin.
High inflation can also spur the Federal Reserve to increase interest rates as it tries to cool off
the economy and slow demand. If the central bank does so drastically, it could even plunge
the economy into a recession, which would also be bad for stocks — along with everyone else.
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