What Is Inflation?
Inflation measures the rise in prices over time. The more prices for food, housing, clothes, healthcare, and other goods and services increase, the greater the rate of inflation.
This guide provides a detailed overview of what causes inflation, how it is calculated, and how central banks attempt to keep inflation low. The guide also explores deflation, hyperinflation, and what investments are best to protect against the ravages of rising prices.
How To Calculate Inflation
Government statistical agencies, such as the U.S. Bureau of Labor Statistics (BLS), measure inflation by calculating how the prices of items that are included in a reference basket change from one period to the next.
For example, the BLS reference basket used to calculate the U.S. Consumer Price Index, a broad measure of U.S. inflation, has over 200 categories of goods and services purchased by households and businesses. These goods and services are divided into eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication.
Why Does Inflation Occur?
Inflation can only occur if businesses charge more to their customers for goods and services. A business will often raise its prices if it finds the cost to produce an item or deliver a service is increasing. Businesses try to pass those higher costs to their customers in order to keep business profits from falling. There is a chain reaction as businesses that sell to other businesses observe higher costs and raise their prices. This leads other businesses to charge more to households. Those household members then demand more compensation from their employers, which increases the businesses’ costs, leading to another round of price increases.
What Causes Inflation?
Inflation occurs when the amount of money in an economy grows faster than the number of goods and services available for sale. Money is purchasing power. The more money households or businesses have in their checking accounts, the greater their purchasing power.
Businesses and households can increase their purchasing power by borrowing money. When a bank makes a new loan, a new digital bank deposit is created, which the borrower can spend. The more banks lend, the more money they create. In most countries, bank lending is the primary reason the money supply increases.
As purchasing power and the money supply expand, there is greater demand for goods and services, as well as for the inputs used to produce those goods and services. If the supply of inputs and final products doesn’t increase as much as demand, that puts upward pressure on prices, leading to inflation.
How the Federal Reserve and Other Central Banks Use Monetary Policy to Control Inflation
Central banks, such as the U.S. Federal Reserve, the Bank of England, and the Bank of Japan are responsible for making sure their country’s inflation rate stays low. Central banks seek to control inflation by influencing the interest rates banks charge on loans. When banks increase their loan rates, households and businesses take out fewer new loans. Fewer loans means less money is created. The money supply doesn’t expand as quickly, keeping inflation low.
Central banks influence lending rates by setting a policy target for very short-term interest rates. These short-term rates include the interest rate banks charge to lend to each other and to borrow money from the central bank. In the U.S., the policy target is called the federal funds rate or fed funds rate for short. By raising or lowering their policy target, central banks set a floor or lower bound for interest rates. The higher the central banks’ policy rate, the more banks need to charge on loans in order to make a profit and the fewer consumers and households are willing to borrow. Fewer loans slows down the rate at which the money supply expands. Actions by central banks to control inflation by influencing interest rates is called monetary policy.
How Capacity Constraints Lead To Inflation
Central banks pay close attention to the capacity of the private sector to produce goods and services. If capacity appears constrained, such as factories are running full tilt, utilities are close to maxing out their power grid, and the unemployment rate is low then that can lead to rising prices. If these capacity constraints occur at the same time banks are accelerating their money creation by lending, then inflation can rise faster than the central bank’s target inflation rate.
Skilled workers are critical to the private sector’s ability to produce goods and services. As more workers get hired and the unemployment rate declines, employers struggle to fill jobs needed to expand the production of goods and services.
In a tight labor market, businesses compete for new workers and try to keep existing employees happy by paying them more. As wages increase, businesses will often raise the prices on their products and services in order to keep existing profitability levels, which leads to a higher inflation rate.
What Is NAIRU?
Economists and central bankers believe if the unemployment rate falls too low that wages and inflation will rise too fast. The level of unemployment below which inflation could increase is called the non-accelerating inflation rate of unemployment or NAIRU for short. No one knows exactly what that rate of unemployment is, but it appears to be around 4% to 5% in the U.S. If the unemployment rate falls below the NAIRU rate, an additional unknown is whether inflation will spike or rise more gradually.
The Neutral or Natural Rate of Interest
In theory, there is a level for short-term interest rates set by central banks that keeps inflation near the target inflation rate while maintaining full employment, a condition when anyone that wants a job can get a job.
The optimal level of rates is called the neutral interest rate. It represents the central bank policy rate at which unemployment is at or near the non-accelerating inflation rate (i.e., NAIRU) and prices are generally stable.
Former Federal Reserve Chair Janet Yellen used the story of “Goldilocks and the Three Bears” to illustrate the neutral federal funds rate, stating that “monetary policy should be at neutral only when economic conditions are ‘just right’.”
More often than not, countries do not have a “Goldilocks” economy. Either unemployment is too high or too low or inflation is too high or too low.
When the Federal Reserve and other central banks believe unemployment is too high and inflation too low, they lower their policy target for short-term interest rates to encourage more bank lending and money creation, which can stimulate the economy and increase inflation and employment.
If unemployment appears to be below the non-accelerating inflation rate of unemployment and inflation and wage pressures are rising then central banks raise their policy rate in order to discourage lending and new money creation.
The challenge central banks face in controlling inflation is that the neutral or natural rate of interest is unobservable. No one knows what that rate is, and it can change over time.
Deflation and Inflation Targeting
Each country’s central bank has a target inflation rate. In most developed countries that target inflation rate is 2% or less. No country has a target inflation rate of zero.
Central banks prefer a low but non zero target rate of inflation because they worry a great deal about falling prices, which is called deflation. Deflation is the opposite of inflation. Deflation can arise when the money supply has stagnated or is contracting because loan balances are falling. Once deflation takes hold, it can be difficult to combat because households and businesses stop buying in anticipation of further price declines. This in turn, further slows the economy and increases unemployment, leading to a downward deflationary spiral, as businesses lower prices even more as they try to spur demand.
Once households and businesses have a deflationary mindset, it can be difficult to overcome, as the private sector puts off spending and borrowing because they believe prices will fall further. In addition, during the economic turmoil that accompanies deflation, individuals want to save more, spend less, and not borrow money out of fear they could lose their jobs. That reduced demand can push businesses to lower prices even more, leading to even greater deflation, particularly if the money supply contracts because the amount of loans outstanding in the economy is falling.
Central banks prefer that households and businesses expect and act as if inflation will stay low, but not too low. This inflation anchoring makes monetary policy easier as households and businesses are less likely to overreact to either rising or falling prices.
For example, if the private sector believes inflation is accelerating, households and businesses might hoard goods and increase their purchases, which can lead to more capacity constraints. Employees might demand higher wages and businesses might increase their prices in anticipation of cost increases from their suppliers. These actions can exacerbate inflationary pressure.
Having the private sector anchored to a low but non zero inflation rate allows central banks to keep their interest rate policy target above zero. That means there is room for central banks to cut their policy target to help stimulate loan demand when the economy is slowing. During periods of deflation, interest rates often fall close to zero, which makes it more difficult for central banks to stimulate the economy without resorting to unconventional policy tools like negative interest rates.
Does the U.S. Consumer Price Index (CPI) Overstate or Understate Inflation?
Earlier we learned that inflation measures the rise in prices over time as reflected in hundreds of goods and services purchased by consumers. As time passes, however, consumer preferences change so the mix of goods and services households purchase changes.
In addition, the quality of goods and services improves. For example, the storage capacity and speed of mobile phones have gotten better over time. Also, automobiles are more powerful and safer.
Government statisticians that calculate inflation have to adjust the product mix that comprises the reference basket to reflect changes in consumer preferences. These statisticians also have to separate out price increases due to quality improvements from those due to rising costs. At times, a product’s price could stay the same, but the quality might be greater, which means that the price actually dropped after adjusting for the quality improvements.
Statisticians adjust the product mix and weights in the reference basket used to calculate inflation because inflation benchmarks such as the U.S. Consumer Price Index measure changes to the cost of living rather than simply the change in prices.
A cost of living index, according to the Bureau of Labor Statistics, “measures changes over time in the amount that consumers need to spend to reach a certain utility level or standard of living.” In other words, what consumers buy and how much they are willing to pay changes based on how consumers measure their satisfaction with life.
Some individuals, such as John Williams of Shadow Stats, believe the U.S. Consumer Price Index understates the rate of inflation because the product mix in the reference basket has changed. He doesn’t believe CPI should be a cost of living index, but it should measure the price changes of a static mix of goods and services. Inflation rates would be much higher than official statistics if the reference basket mix stayed the same and there were no adjustments for quality improvements.
Others believe inflation is understated because government statisticians are not aggressive enough in adjusting official inflation statistics to reflect product improvements and substitutions. Substitutions are when consumers swap out more expensive products for those that are cheaper and nearly as good.
The bottom line is there is a lot of subjectivity when it comes to how inflation is calculated. That is why central banks target a low but non-zero rate of inflation. If the target inflation rate was zero, it is possible a country could be experiencing deflation but not know it given all the vagaries in calculating the official inflation rate.
What Is Hyperinflation?
Hyperinflation occurs when prices are rising by more than 50% per month. Periods of hyperinflation, such as what occurred in Zimbabwe in 2008 and 2009, and what Venezuela is experiencing today, can see inflation rates higher than 10,000% per year.
Venezuelan journalist Virginia Lopez Glass wrote, “Inflation is bad, but hyperinflation is a totally different game.” Hyperinflation can destroy an economy. Attempts to stem the hyperinflation through price controls cause businesses to stop producing because they can’t make a profit. Store shelves go empty and people struggle to get enough to eat.
What Causes Hyperinflation?
Hyperinflation is caused by a massive increase in the money supply coupled with a severe contraction in the supply of goods and services. The spike in the money supply is not due to bank lending. Rather the federal government, led by corrupt leaders, spends substantially more than it receives in tax revenue. By some estimates, the Venezuelan government has stoked hyperinflation by running budget deficits equal to 30% to 40% of the nation’s gross domestic product (GDP). GDP measures the value of goods and services produced in the country.
Such extraordinary levels of spending lead to a lack of confidence in the government. The country’s currency plummets in value relative to other currencies. This causes the prices of imports to spike, which further exacerbates the hyperinflation.
Hyperinflation occurs because governments essentially run the printing press to pay for things. They often do this because leaders have tenuous political control so they want to reward the factions that help keep them in power, such as the military.
How to End Hyperinflation
Hyperinflation ends only when governments stop expanding the money supply by overspending and households and businesses have faith in the currency again. This usually requires pegging the value of the currency to a more stable currency such as the U.S. dollar. Or even replacing the local currency with the U.S. dollar like Zimbabwe did in 2009 in order to end its hyperinflation.
Often credibility in the government and currency can only be reestablished with a leadership change or by bringing in a neutral third party like the International Monetary Fund to monitor spending and provide financial assistance.
Is Inflation Bad?
Clearly, hyperinflation is bad because it arises due to corrupt leadership and indiscriminate spending. High inflation is also bad because it signifies demand has exceeded the capacity of the private sector to produce goods and services. High inflation indicates central banks are losing their ability to both control inflation and keep inflation expectations low.
Low levels of inflation, however, are not inherently bad. Low inflation is part of a modern economy. Inflation exists because bank lending leads to the expansion of the money supply. Central banks allow for some inflation because it provides room to cut interest rates when an economy is slowing and provides enough of a cushion to protect against deflation.
Even though low inflation is not inherently bad, it does extract a cost as prices rise over time. A dollar worth of goods or services in 1967 would cost $7.33 today. Or put another way, a dollar today in terms of its purchasing power is equivalent to 14 cents in 1967.
The long-term cost of rising prices requires individuals to save and invest in a way to offset the inflationary impact.
Best Inflation Hedges
Investors can protect or hedge against inflation by owning assets that perform better than inflation over the long-term. That means the investments have a positive real return. An investment’s real return is calculated by subtracting the inflation rate such as the Consumer Price Index from the nominal rate of return on the asset. An investment’s nominal rate is usually the rate of return reported by the investment’s sponsor. Typically assets with higher long-term expected real rates of return also exhibit higher volatility in that the returns can vary significantly from year-to-year. Due to this volatility, higher real returning assets can go through short-to-intermediate term periods when they lag the rate of inflation.
Treasury Inflation Protection Securities as Inflation Hedges
Inflation-indexed bonds such as Treasury Inflation Protection Securities or TIPS are the surest way to perform in line or better than the inflation rate. That’s because the value of these bonds is adjusted based on the inflation rate. Consequently, an investor can be quite confident of thier inflation protection.
Unfortunately, the surety that the bond will keep pace with inflation also means the real rate on these bonds is low. As of the end of February 2020, the real yield on 10-Year TIPS was -0.2%. A negative real yield for TIPs means the bonds could lag behind inflation by the real yield amount; in this case by 0.2%.
Stocks as Inflation Hedges
Stocks have been an excellent inflation hedge over the long-term as they have exhibited a positive real return of 4% to 9% depending on the time period and stock index measured. Stocks represent equity ownership in publicly traded companies. Most companies are able to pass rising costs on to their customers so that profits and the share of profits paid to stockholders in the form of dividends rise greater than the inflation rate. Stock prices are volatile so stocks can trail inflation over the short-to-intermediate term in a down market.
Real Estate as Inflation Hedges
Rental real estate, including publicly traded real estate investment trusts or REITS, have also been great inflation hedges, exhibiting positive real returns over the long-term. Property owners are able to increase rents over time to compensate for inflation. As a result, the value of the rental properties and REITs also keep pace with inflation, although REIT prices are volatile like stocks so REITs can lag inflation in the short-to-intermediate term in a down market.
Gold as an Inflation Hedge
Gold has performed better than inflation over the long-term, but it has also gone through lengthy periods when it has lagged inflation. There is no cash flow with gold. So unlike real estate and stocks that can see their cash flows increase by the rate of inflation, the only way gold will outperform inflation is if investors bid up the gold price in the future. Historically investors have, but there is no guarantee that gold will continue to perform better than inflation. Consequently, stocks, real estate, and TIPs are better inflation hedges than gold.
Other Commodities as an Inflation Hedge
Most other commodities such as oil, natural gas, industrial metals and agricultural products have performed better than inflation in the long-term, but similar to gold they have lagged the inflation rate for lengthy stretches. In addition, most commodities cannot be held directly in the same way that an investor can own gold. Consequently, investors have to invest in commodities futures directly or via a mutual fund or ETF that owns commodity futures. The complex pricing and structure of commodity futures makes them less attractive as an inflation hedge compared with TIPs, stocks, and real estate.
Inflation rates fluctuate based on the strength of the economy and actions by the private sector, central banks, and commercial banks. Rising inflation reduces household and business purchasing power over time. Fortunately, there are investments available that allow individuals to stay ahead of inflation and growth their wealth on a real, net of inflation basis.