Inflation: What It Is and What It Isn’t

Inflation has become a buzzword since the price of our Chipotle burritos went from $8 to $12 seemingly overnight. The definition of inflation is simple, it’s the rise in prices of goods and services. Inflation is not a cause, and it is not a “thing” that comes out of the woodwork to destroy an economy. It is simply a term used to describe the rise in prices while lowering buying power.

What Does “Lower Buying Power” Mean?

Lower buying power means that your money purchases less today than it did years ago. Your dollar is still worth a dollar you just can’t buy as much with that money as you did in the past. This is a common theme we see in the world today. Groceries, insurance, housing, along with other items, have become more expensive with little likelihood of dropping in price. This is the negative effect of inflation.

Inflation Isn’t All Bad

Inflation, in slow doses, is helpful to an economy. The Federal Reserve (FED), the controller of monetary policy, aims to keep inflation at 2% every year. This is important because 2% is a healthy increase in prices while keeping an economy stimulated. If prices never went up, consumers would be less incentivized to buy today. When people buy/spend less, economies slow down. When economies slow down, businesses do worse which leads to less jobs, more unemployment, and harder times.

Why Inflation Has Become a Buzzword Since 2020

Whenever inflation rises above the FED’s targeted 2% rate, economists swiftly look for the root cause in order to avoid hyperinflation. Since 2020, inflation has been a hot topic as it peaked above 9% on an annualized basis. If prices went up 9% every year, the cost of products and services would double in just 8 years...

In order to determine why this happened, we need to understand the main causes of inflation.

Main Causes of Inflation:

Supply Problems: When the supply of a specific product plummets, the price will increase due to scarcity of that item. When the supply returns, prices normally come back down. Often times this happens to oil prices during war times.

Money Supply: On the demand side, an increase in money-supply causes inflation due to consumers having more dollars to spend. If you only have $10 and a candy bar cost $5, you may not buy the product. However, if you were given $100 and the cost of the bar remained the same, you’d be more willing to buy the candy.

Expectations: When people expect prices to remain the same, there is little rush to buy a product. When prices are rising rapidly, people want to buy it that day to avoid paying a higher price tomorrow. This is why mindset alone can cause inflation and often is the backing to a handful of other economic phenomena.

During the pandemic, the government wanted to keep the economy afloat by increasing the money supply so consumers would be more willing to spend. Because the supply of money increased, the demand for products and services followed suit. Tagging along were supply chain issues that created a strain on the supply of many goods. These two factors combined created higher prices that we still do a double take to today.

How Do We Control Inflation?

The best tool the Federal Reserve has to control inflation is through interest rates. That fun number that affects mortgages, auto loans, and savings accounts is mostly controlled by the FED. When spending is high, causing inflation, the FED will raise interest rates to 1. Make loans more expensive and 2. Incentivize saving money in a savings account or bond. This is why interest rates are significantly higher today than they were even a few years ago.

As inflation comes back down towards the 2% rate, interest rates will follow suit. Inflation is like a party of teenagers and interest rates are the amount of parent’s home to watch the house. When interest rates are low or 0, the party often gets out of control. When rates increase, the party simmers down.

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