Almost every day, the news headlines include stories about inflation. We hear and see evidence of it constantly in our daily lives but what is inflation and why is it important? Let’s take a look at and analyze inflation this year, particularly inflation in the USA. Please note that all opinions expressed in this post are my own and do not represent my employer or any organizations where I am employed or affiliated.
What is inflation?
Inflation is an increase in prices over a time period or a decrease in purchasing power of your money. When your income stays the same and prices increase, everything gets more expensive.
Government agencies measure the price level by creating a basket of goods and services that households typically consume. These agencies establish a price index by determining the value of this basket of goods and services at a base period and compare it to today’s prices. Inflation is the percent change of the price index. In the US, the Bureau of Economic Analysis (BEA) and Bureau of Labor Statistics (BLS) measure inflation.
Over the last 12 months, the BLS reports inflation was 7%. This is the largest 12-month gain since June 1982!
Why you should care about inflation?
People with money in the bank are barely earning any interest. Depending on your bank, you could earn 0% on some savings/checking accounts and up to 0.5% on select high yield savings accounts. If you account for inflation,
7% inflation rate – 0.5% bank interest = 6.5%
you’re losing at least 6.5% of your money by leaving it in the bank.
As interest rates rise, banks will increase their savings rate returns but this might not be enough to counter the loss of purchasing power due to inflation.
If you are looking for a risk free investment to park your money and keep up with inflation, read my post about investing in US Treasury I-Savings Bonds which are currently yielding 7.12% through April 2022.
Observing Inflation in the US
Throughout 2021, you probably noticed the increases in prices for gas at the pump, cars, utilities, furniture, and food.
New and Used Car Purchases
During the pandemic, I relocated to the suburbs and needed a car. Due to chip shortages, new cars were limited and dealers were asking way about MSRP. Used and pre-owned cars weren’t much better. Towards the end of 2021, the price of a used car was more than $27,500, up from $20,084 in 2018.
Food
The cost of food has steadily increased. The price per pound for meat, poultry, and fish went up. Some companies are clever and keep the price the same but reduce the size of the packaging hoping that customers don’t notice. As an example, a few years ago, orange juice was sold in 64 oz containers, then the size was reduced to 59 oz and most recently, the container is 52 oz. This is a form of hidden inflation where you are paying more for less.
Restaurants
If you go out to eat, many restaurants feel the same pressures as the cost of food, rent, and other supplies have gone up. To pay the extra costs and maintain the same profit level, restaurants have increased menu prices. In the 1970s and 1980s, prices rose so fast that some restaurants updated their menu prices with stickers. In today’s world, it’s easier to update digital menus but some restaurants and retail establishments have extra overhead to print new menus or signage. Places like Dollar Tree and 99 cent stores have to up their prices (and change their names) and adjust customer’s expectations going forward. In New York City, $1 pizza slices may be a relic of the past. New York’s $1 slice is no longer a dollar.
Impact on Budgets
For typical household spending, the largest categories are the areas that are experiencing faster than normal price level increases. This includes housing (25-35% of a home budget), transportation (10-15% of a home budget), food (10-15% of a home budget) and utilities (5-10% of a home budget). Retirees, seniors, and others on fixed income pensions or fixed nominal term payments are particularly susceptible to increasing prices. They might be forced to consume less or spend more of their savings to maintain their current lifestyles.
Wage Increases and Taxes
Some employers may increase wages to adjust for inflation. Taxes are not tied to inflation and those with increasing income can be hit with a bigger tax bill at the end of the year. Higher wages might push people into higher tax brackets where your tax rate might increase.
Lending and Investing
People who have debt based on fixed interest rates may benefit from inflation. With potential wage increases, you’ll have more money to allocate to paying back debt payments, especially if they are fixed. Yet, uncontrolled inflation makes it difficult for lenders to predict payments and profitability so banks and lenders may be cautious about making new loans available. Companies might have the same perspective where the inflation uncertainty could cause them to postpone hiring or spending on big projects.
Businesses want predictability and closely monitor and forecast inflation expectations. Inflation was very low for more than a decade and uncertainty about the future has caused volatility in the stock market.
We started seeing inflation take off in the second half of 2021 and it is likely to continue into 2022. Some forecasters are expecting inflation to work itself out over the next few months. Some analysts feel that the inflation we are seeing is due to the surge in consumer demand compounded with the disruption to the supply chain attributed to the covid-19 pandemic. Over time, they predict that we will see a rotation and a decreased demand for goods and an increased demand for services. Only time will tell.
Controlling Inflation
The Federal Reserve Bank has signaled that it will take action to control inflation. The Federal Reserve conducts monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates1.”
To control inflation, the Fed needs to reduce the money supply and increase interest rates. As interest rates increase, saving is encouraged rather than spending. This leads to slower growth. The Federal Reserve Bank is a central bank that controls the fed funds rate, the rate that banks borrow money. If the fed funds rate increases, commercial banks will follow. This action makes it more costly to borrow and influences behaviors.
As an example, if your savings account pays 0%, you’re more likely to spend your money since there’s little benefit to save it. But if your savings account interest rate were to increase to say 3%, you might decide to put more money into your savings account to earn interest on your money and let it grow.
The Fed is adjusting its policy. Inflation is more widespread than originally forecasted. At the same time, the Fed has to weigh the state of the economic recovery and unemployment rate. The difficulty is to find a balance and avoid a recession. In the early 1980s, inflation was an issue and the Fed’s actions led to a recession.
Summary:
As you listen to headline news stories about inflation and soaring US consumer prices, you now have some background in what inflation is and what it means to you. This post focused on inflation this year and how it has impacted several areas of the US economy.
