Econ 101: Inflation and the Economy

Our listener Eric has made an appearance in the past to school us on bonds. Today he’s back to teach us about inflation.

What Is Inflation?

Economic concepts can be broken down into the micro and the macro. Micro looks at the smaller picture concerning the behaviors of individual consumers and businesses. Macro is the study of the economy as a whole and where inflation falls.

Inflation is one economic concept that most of us see on a regular basis. It’s the purchasing power of your money, the general increase of the cost of goods and services over a specified period of time. Your dollar that is worth X today will not be worth X five years from now.

Consumer Price Index

One of the best measures of inflation is consumer price index. CPI measures changes in price of a set of consumer goods and services purchased by households. There are eight major groups that include the costs of things like cereal, rent, dresses, gas, prescription drugs, televisions, college tuition and funeral expenses.

The Big Mac index was founded as an informal way to compare purchasing power between different currencies but has been expanded to include the amount of time someone has to work in order to buy a Big Mac.

Demand Pull Inflation

In most cases, we want inflation to increase, but not too steeply. Controlled inflation can erode the cost of debt. Good inflation is known as demand pull inflation and happens during periods of economic growth and increased income. Consumer demand increases.

Wartime is a good example. Who buys a lot during wartime? The government and it buys from the private sector. When a big order comes in to Lockheed Martin, the company hires more workers. More people have money and they too, spend money in the private sector buying cars and homes and electronics.

Cost Push Inflation

Cost push inflation is the “bad” kind of inflation. A good example would be when there is a drought. There is less food available which causes price increases. The producer has to make money but they have less product to sell. So what do they do? They raise the price.

The ongoing drought in California and the water restrictions being imposed because of it, are going to make rice more expensive. California is the country’s second biggest rice producer(who knew!) and will grow 25% less than last year. So your sushi is going to get more expensive.

Federal Funds Target Rate

The federal funds target rate is “the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.” The higher the federal funds rate, the more expensive it is to borrow money. The Federal Open Market Committee meets eight times per year to set key interest rates.

Stagnant Wages

Inflation has been low, but our wages have been stagnant for decades. After adjusting for inflation, today’s average hourly wage has just about the same purchasing power as it did in 1979. Productivity and Gross Domestic Product have increased, but wages for the average worker have not. This stagnation is one of the reasons the Fed has been reluctant to raise rates.

Deflation

Deflation is a drop in consumer prices and measured using the CPI. This sounds like a good thing for consumers but is a sign of a long term decrease in demand and signals that a recession is probably already happening. Manufacturers and sellers of goods start cutting prices and if this goes on long enough, it also means they will cut employee wages or even go out of business entirely.

Disinflation

Disinflation is the slow down in the rate of inflation. If the inflation rate is already very low, then disinflation could lead to deflation.

Stagflation

Stagflation is when prices of goods and unemployment increase while spending decreases. Usually there is an inverse relationship between inflation and unemployment; inflation goes up and unemployment goes down but that doesn’t happen during a period of stagflation.

Why Raise Rates?

Why would we ever want the Fed to raise interest rates? We want to keep borrowing money for cheap! Well, that’s if the bank will lend you money. They are more tight fisted with loans when interest rates are very low. Savers, especially retired people who are no longer working to earn money, will see more growth in their money.

Fractional Reserve Banking

Fractional reserve banking means that banks only have a fraction of the money they take in through deposits as actual cash on hand. The rest of the money is lent out. This is possible because it’s rare that so many people would decide to take out cash at the same time, that the banks would not have enough to comply. That is known as a run on the banks and happened during The Great Depression and recently in Greece.

How Does Inflation Affect Me?

Inflation isn’t all bad. If you have debt and inflation rises, the debt becomes less valuable. Day to day, inflation is not that noticeable as long as it’s controlled and somewhat consistent. It’s the long term that we have to be concerned about, particularly as we near retirement. A million dollars might seem like a nice goal to shoot for but one million today is not one million thirty years from now.

Cash Is The Riskiest Investment

Afraid to invest your money? Think it’s safer in your savings account making less than 1% interest? Noooooo! If the rate of inflation is higher than your interest rate, you are losing money. You would be almost in the same situation if you buried the money in your yard as you are having it those low interest bearing accounts.

What If It Goes Up?

Rates are going to be raised at some point. The Fed hasn’t raised them since June 2006! So something’s got to give and it’s likely to be sooner rather than later. What should you do as an investor?

Remember, if you’re just letting your money sit in a bank account while you wait to see what happens, you’re losing money. If you’re very nervous or very conservative, Eric recommends investing in fixed income securities like government bonds. Your return won’t be big but it will be guaranteed.

Inflation Affects Everything

There were a lot of different topics discussed under the umbrella on inflation but that’s because inflation affects so many areas of the economy. But the bottom line is that you don’t have to think about it day to day, but it starts to matter when you are considering how much you need to retire on.

Show Notes

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