Financial Fact: What is Inflation?

What is it?

Even if we may not be able to offer an in-depth analysis on inflation, most of us can point to our first-hand experience of how much it is costing us because we are spending more and ending up with less for our money. Prices have gone up on just about everything over the last year, and most Americans are cutting costs in one way or another. There are numerous reasons for these significant price increases and much of it can be attributed to the effects of the global pandemic. A simple definition -- inflation is a rise in prices of the goods and services that are produced by our economy and that are necessities for most Americans. This leads to a reduction in purchasing power because how much a dollar can buy is reduced when compared to how much could be bought with a dollar in previous years. Inflation can be caused by several different factors such as higher wages, lower interest rates, or supply chain issues, or a combination of these and other issues in the global economy.

According to the CPI Inflation Calculator, $50 in 1930 is equivalent in purchasing power to about $887.05 today, meaning that $50 in 1930 could purchase goods valued at $887.05 in today’s economy. However, the inflation rate in 1930 was -2.34%. The current inflation rate is now 8.52% as of this writing.¹

How is inflation measured?

As with several matters concerning the US economy, we turn to the Bureau of Labor Statistics to understand how inflation is measured. The most frequent approach uses the Consumer Price Index for Urban Consumers, (CPI-U) to measure the shift in prices that urban consumers pay for the most common goods and services that are purchased each month. The urban consumer group represents the overwhelming number of Americans at 93% of the total US population. Information is drawn from surveys that keep track of what American consumers are spending their money on.

The CPI-U index groups together four types or categories of goods purchased, food, energy, commodities such as cars, clothes and appliances and, essential services like rent, mortgage and healthcare. Not all categories are given the same weight when measuring inflation. In general, the order of importance is services and commodities which tend to be more stable followed by food and energy.

USA Facts points out that “The overall CPI, also known as “headline” CPI, is measured by the percentage of change in these categories from one period to another. Since food and energy categories are typically much more volatile than the other parts of the CPI, economists often focus more on a metric called the “core” CPI which excludes these two categories.”²

What steps are taken to manage inflation?

The Federal Reserve Bank (The Fed) has two primary approaches they can take to manage inflation while also keeping the economy on a steady course—adjusting interest rates or quantitative easing. When interest rates are adjusted up by the Fed, as is occurring now, it decreases the money in the US economy because the cost to borrow money goes up and people generally spend less, hopefully resulting in a cool down effect on inflation. Quantitative easing is typically utilized during periods of very low growth or during an economic crisis like the Great Recession. Investopedia defines it as “a form of monetary policy used by central banks to increase the domestic money supply and spur economic activity by purchasing government bonds and other financial instruments, such as mortgage-backed securities (MBS).”³