What Is Inflation?
Inflation is not a new concept. In fact, it's been around for centuries. In the Middle Ages, people used to trade goods and services in order to avoid inflation. If you wanted to pay for something, you would simply trade your goods for something else.
Inflation affects everything in your life because it is the decline of purchasing power of a currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.
If you've ever looked at your grocery receipt and noticed that food prices have gone up, you've witnessed inflation. Inflation is a major problem for people on fixed incomes, because it makes it harder to save money. When economists talk about inflation, they are referring to the rate at which prices rise.
Inflation is a significant issue in today's economy since all of us buy and sell goods and services every day. Inflation affects your ability to buy these goods and services.
How is Inflation Measured?
The Fed measures inflation uses a core index by looking at the price of a basket of goods and services, often excluding the most volatile items like food and energy.
The Bureau of Labor Statistics (BLS) publishes CPI data annually. The CPI measures changes in the prices of a fixed number of consumer items, and is used by the Federal Reserve Board to set the target rate of inflation. The Consumer Price Index is the best measure of inflation because it includes prices paid by businesses, which are affected by many factors other than inflation.
The Personal Consumption Expenditures Price Index is the Federal Reserve's preference in the United States. This is due to the fact that the PCE covers a broader range of expenditures.
When the CPI is used as an inflation measure, the CPI-U, which is the "core" inflation measure, is used to calculate the change in the consumer price index. The core CPI is a subset of the CPI, which excludes food and energy. The core CPI is used to calculate the change in the CPI. The CPI-W is the measure of changes in wholesale prices. It's used to calculate the change in the CPI.
How Does Inflation Work?
The Federal Reserve and Inflation
The Federal Reserve System is the central bank of the United States. It comprises of 12 regional Federal Reserve Banks that issue currency and regulate the nation's banking system. The Fed's main aim is to maintain price stability in the economy, which it achieves by keeping the quantity of money in circulation stable relative to the economy's needs.
Consumer Price Index (CPI)
The most widely used measure of inflation in the United States is the Consumer Price index. It shows the change in the average price of a basket of consumer goods and services purchased by households across the country. Since the mid-1960s, it has been published monthly by the Bureau of Labor Statistics and has been a factor in determining cost-of-living adjustments for Social Security.
Causes of Inflation
The tendency for prices to go up is known as inflation. It happens when the supply of money is increasing faster than the amount of goods and services being produced.
This causes prices to go up because the purchasing power of a dollar or a unit of currency goes down. The most common reason for this is when the government increases money supply, which is usually done by printing more money.
Higher money supply is the root of inflation, though it can work through different mechanisms in the economy. Money supply is increased by the monetary authorities by printing new money, legally devaluing (reducing the value of) the legal tender currency, or borrowing money from banks at interest.
In all such cases of money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand pull inflation, cost push inflation, and built in inflation.
Types of Inflation
Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and built-in-inflation. The most commonly used inflation indexes are the Consumer Price Index (cpi) and the Wholesale Price Index (wpi). If you read the news and following economists, inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
Demand pull inflation occurs when the supply of a product suddenly increases and the demand remains the same. This causes prices to rise, and the effect is magnified because the supply is limited and new units cannot be produced quickly enough to meet the increased demand.
When the Federal Reserve raises interest rates, it's called a "tightening" of monetary policy. As a result, consumers spend less on goods and services, which leads to a decrease in aggregate demand. When the Federal Reserve lowers interest rates, it's called a "lengthening" of monetary policy. As a result, consumers spend more on goods and services, which leads to an increase in aggregate demand.
Cost push inflation is the overall price increase of an item due to the increased cost of wages and the rise in material cost to produce that good or service The price increases that are passed on to the consumer can be caused by the rising cost of production.
Many large retailers, like Wal-Mart, are experiencing price increases due to increased production by their suppliers. This is an example of cost push inflation in which price increases are passed on to the consumer.
The cost-push effect can be attributed to the fact that it is easier to raise prices than it is to lower them. This is because it is easier to move prices up than it is to move them down. So, when there is an increase in demand for goods, it is much easier to pass on higher costs to customers than it is to lower them. Therefore, businesses often raise their prices when they have little choice but to do so.
Can Inflation be Controlled?
The goal of central banks is to achieve two objectives: maintain price stability and foster maximum employment.
If you are familiar with the Federal Reserve System in the United States, then you understand that they are the central bank for the country. The main function of the Fed is to control the money supply. To do this, they can raise and lower interest rates and tighten or loosen banks reserve requirements. This can have a major impact on the economy and the stock market.
Raising the reserve requirement restricts banks lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity. A government at times will attempt to fight inflation through fiscal policy.
Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity.
Economists and policy makers believe the best way to combat deflation is with monetary policy. The Federal Reserve (the central bank) can use the money they create by lending out money. They can also use their influence on interest rates to help stimulate the economy.
Does Inflation Impact My Investments?
As the inflation rate rises, so does the interest rate. Higher rates mean less purchasing power for investors, and inflation eats away at the purchasing power of your fixed income investment.
While the stock market is volatile, the truth is that the stock market is an effective long-term investment, and the returns will more than likely make up for the ups and downs. It's important to remember that stock market investing is not a get-rich-quick scheme since stocks are long-term investments. It's true that if you buy individual stocks, you could potentially lose money. However, as a group, the stock market tends to outperform other investment vehicles over the long-term.
What About Bonds, Gold, or Crypto?
TIPS are a type of bond that are protected from inflation.
A Treasury Inflation Protected Security (TIPS) is an interest-bearing U.S. government security that is designed to protect investors against the risk of inflation. It is also known as a "bond-like" security because of its similarities with bonds. The principal of a TIPS bond is linked to the Consumer Price Index, which is a measure of price changes for consumer goods and services.
TIPS are a type of bond that is issued by the government. TIPS have a coupon rate that is fixed, but the payment of interest varies depending on how much inflation has occurred over the previous 10 years. This is why it is important to check on the current interest rates and look for TIPS that have a low yield.
You may have heard of the term the "Gold Standard" and wondered what it means.
The Gold Standard is the means to value a currency (like the dollar) by linking it to a precious, limited supply metal. For example, when the U.S. was on the the Gold Standard, gold was kept in reserve and linked to the dollar. The U.S. left the domestic Gold Standard in the 1930's (the Great Depression) due to people hoarding gold instead of depositing it in the bank. In the 1970's, the U.S. ended the gold standard for international convertibility. The U.S. dollar is now the reserve currency and the international standard of monetary measurement.
For investors, it is believed that gold is an inflation hedge because it is seen as an alternative asset to cash. There is a correlation between the price of gold and the inflation rate. Paper money is a representation of value, and it's not hard to understand why gold is a valuable commodity. When the dollar is losing value, people may be less inclined to purchase it.
Many consider gold to be a good investment because it is a tangible asset and is therefore unlikely to lose value in a deflationary environment. However, in a hyperinflationary environment, gold could lose value.
Bitcoin is a digital currency that was created in 2009 and has been growing in popularity. It is a decentralized currency that is not controlled by any government or bank. It is called a “crypto” currency because it is not printed or minted but generated through a process called mining. Miners use powerful computers to confirm transactions and add new coins to the blockchain.
Many believe that digital currencies are the future of money because of what is called blockchain technology. This new technology is changing the way that people around the world send money, invest in stocks and make payments. There is a debate regarding the intrinsic value of crypto currency and the very real possibility that it could replace fiat currency as the world's most widely accepted means of payment.
It is important to note that crypto is very volatile and is subject to large price swings that create fear and panic for many investors. The peaks and valleys can be unsettling for many.
Crypto's popularity will continue to grow if investors see it as an overall portfolio diversifier and as a new and emerging asset class. There is not a lengthy history of return data on crypto especially as it relates to inflation since inflation rates have been so low since its creation.
While there is not one universally accepted study, the consensus is that inflation has a negative effect on stock returns. However, the magnitude of the effect depends on how much inflation is present in a given period. The last time inflation was this high was in the 1970s. But that didn't seem to affect stock returns much. And while we may see a return to higher inflation in the coming years, it's not clear that stocks will be hurt by it.
The stock market is like any other investment. You can't predict whether it's going to go up or down. So you need to be ready for the unexpected, which is why you need a diversified portfolio that includes both stocks and bonds.
Prices go up and down over time as make more goods and services available. Economist and forecasters cannot predict with accuracy future inflation rates as it depends on so many factors, such as the economy, government policies, and unknowable events.
For more information on how inflation affects your spending, the U.S. Bureau of Labor Statistics has a CPI Calculator based on historical data. You can use the calculator at this link.