The Effects of Inflation

By Brittany N. Cox
Registered Investment Advisor at Nestlerode & Loy Investment Advisors

It’s hard to read the news in the morning and not see a reference to inflation lately, so I feel it is worthwhile to talk about what inflation is and what it means for us.  

The core definition of inflation according to Investopedia is “a sustained increase in the general level of prices for goods and services in a region and is calculated as an annual percentage of change.” The value of a dollar is expressed in terms of the amount of real, tangible goods or services that it can buy at a given time. This is the purchasing power of a dollar. When the level of inflation increases, the purchasing power of a dollar decreases. Theoretically, if the inflation rate is at 2%, a $1.00 candy bar will cost $1.02 a year from now. So, you can either look at it from the perspective that the dollar decreased in value or that the price of the candy bar increased. 

So, what causes inflation? There is no straight or short answer for the cause of inflation, but a few types of inflation describe the cause for change. Demand-pull inflation is caused by the overall increase in demand for goods and services, and an increase in demand causes an increase in prices. This is described as “too much money chasing too few goods.” If demand is growing faster than supply, prices will increase. Cost-push inflation occurs when companies’ costs of production go up. When company costs increase, the price of their products must increase to maintain their profit. Other costs that increase for companies are wages, taxes and imports. Lastly, there is monetary inflation. This is caused by an abundance of money in the economy. If there is too much supply, the demand decreases, and the prices go up. If that supply is money and the value of money decreases, the prices of everything that money buys will increase.

The annual inflation rate for the United States is 1.6% for the previous 12 months ending in June 2019 compared to 1.8% previously, as published on July 11, 2019 by the U.S. Labor Department. In other words, $1 in 2017 is equivalent in purchasing power to about $1.02 in 2018. The 2017 inflation rate was 2.13%. The inflation rate in 2018 was 2.44%. The 2018 inflation rate is higher compared to the average inflation rate of 1.23% per year between 2018 and 2019. 

Where do these numbers come from? In North America, there are two main price indexes that measure inflation. The Consumer Price Index (CPI) is a measure of price changes in consumer goods and services. The CPI measures price change from the perspective of the purchaser. The Producer Price Indexes (PPI) is a family of indexes that measure the average change over time. PPI measures the price change from the perspective of the seller. The U.S. Bureau of Labor Statistics researches and records the prices of about 80,000 items each month to gather this data. 

Inflation affects different people in different ways. Some benefit from the effects at the expense of others who lose out. If the inflation rate is anticipated to increase, which is the case for 2019, we can try to compensate so that the impact isn’t nearly as severe. For example, banks can change their interest rates and employers can anticipate wage increases as prices for goods and services increase. Inflation affects your buying power, and therefore it is a concern to those saving money for future use. If your rate of return does not keep up with the increase in inflation, your purchasing power erodes. For retirement savings, this means your savings will not go as far in retirement because it will not buy the same amount of goods and services in the future. 

What effect does inflation have on the economy? Inflation does encourage spending and investing. Since cash will only lose value, people prefer to buy now instead of later. For average consumers, this means things like filling up the gas tank, stocking the freezer with food, buying the next size up on kids’ clothes for future use, etc. 

The Federal Reserve changing interest rates also plays a role in inflation. The idea is that the lower interest rates are, the more money people can borrow, providing more to spend. The more they spend, the higher inflation rises. When rates are increased, however, people tend to save more money and spend less. So, less money being spent means a slower economy and a decrease in inflation. There are discussions about the first U.S. interest rate reduction expected at the end of this month. The Fed set a goal in 2012 to reach 2% inflation and has missed it every year since. The Fed set the goal, as a way to keep businesses and households looking forward and help assure a modest pace of price and wage increases. The Fed is concerned that if they continue to undershoot, they will lose credibility and their statements and policies will become less effective. 

We should all be keeping an eye on the Fed’s interest rate changes and how it will affect the economy. If inflation is rising, you should be vigilant in budgeting your own money. Proactively changing your spending habits to offset the impact of rising inflation will help ease the burden for your budget.