The Return of Inflation, And Why It Matters

The Return of Inflation, And Why It Matters

After a long hiatus, inflation is returning to the United States. In mid-February, the Department of Labor reported that the national Consumer Price Index (CPI), which measures sticker price across a broad basket of consumer goods, jumped more than two percent this January versus the same period a year before—posting its biggest year-over-year gain in more than twelve months. This increase wasn’t driven by any one category of consumption: the average prices of nearly every consumer good, from clothes and food to medical care and gasoline, all increased compared to last year.

The stock market didn’t react well to the announcement, with the Dow Jones average dropping about a hundred points once the report was released. In the weeks and months since equity markets in the United States have been choppy. But the bankers of the Federal Reserve—America’s central bank—were probably pleased by the news, since they’ve been waiting for the rate of inflation to increase for more than six years.  

Why is the stock market so jittery about rising inflation, while the Fed welcomes (some of) it? Isn’t inflation bad because you get less bang for your buck? Can inflation be good for the economy—and at what point do investors and consumers have to worry about it? To help make sense of what higher inflation means for your finances, we’re going to walk through what it means, why it happens, how it’s measured and why it matters.

Inflation Refresher: Why It Happens And How It’s Measured

Inflation is the term we use to describe a broad-spectrum increase in prices across the entire economy. When inflation strikes an economy, the same number of dollars buys less of a good or service over time, resulting in a decrease in your real purchasing power even though your nominal purchasing power, or the number of dollars you have, stays the same.

We measure inflation in a few different ways. The first is the CPI, which is calculated by the Department of Labor by averaging price changes in a predetermined basket of consumer goods and services. The Federal Reserve prefers to use the personal consumption expenditures (PCE) index, which measures changes and weighs inputs differently than the CPI. There’s also the producer price index, or PPI, which measures changes in prices received by domestic producers like Ford or GM for their output—but this index is growing less useful as economies like the U.S. evolve in composition away from manufacturing and toward services.

These indices are different ways of measuring the same thing—how prices are changing, on average, in the economy at large. But why does inflation happen in the first place?

When picturing the root cause of inflation, many people might imagine printing presses running wild and spitting out gobs of bills, like Zimbabwe in the past or Venezuela today. But there are many reasons why prices increase across an economy, and we can separate them into two main buckets.

The first cause of inflation is called demand-pull inflation and it’s the most common type. This is what happens when demand for goods increases so much that there isn’t enough supply, which makes sellers raise prices. In other words, the problem is “too much money chasing too few goods.”

What are some reasons that overall demand for goods might increase? Expansion of the money supply—when the government “prints money” by deficit spending, or the Fed uses the tools of monetary policy to do things like let banks lend more money—is one reason, because when you have more dollars in hand, you’re likely to spend more. Another driver of inflation is fiscal policy, like a tax cut. When the government gives consumers or businesses a break, some portion of those increased earnings will be directed toward consumption. Finally, a growing economy will naturally generate inflation, as confident consumers and businesses spend more.

The second driver of inflation is called cost-push inflation, and it happens when there’s a shortage in the overall supply of goods. Rising wages can also cause cost-push inflation because the employers who pay them pass that cost along to customers. The economist A.W. Phillips was the first to point out the inverse relationship between unemployment and inflation—the fewer people are looking for work, the greater the need for companies to raise wages to attract them.

Other things that can increase the cost of production are higher taxes, government regulation, and shocks in the price of raw materials and key commodities. The OPEC oil crisis of the 1970s caused dramatic cost-push inflation in the United States, with prices increasing up to 10% in a year—because petroleum was such a crucial input across the entire economy, the rise in its price made prices across the entire economy go up.

The Inflation “Goldilocks Zone”

The key point to keep in mind is that while too much inflation is bad, a little inflation goes hand-in-hand with a strong economy.

The Federal Reserve sets its target annual inflation rate for the United States at 2%, which it judges to be the best way to fulfill its goals of maintaining price stability—so consumers can predict with confidence how prices move over time—and keeping the economy as close as possible to full employment.

Why An Uptick In Inflation Is A Big Deal

The reason that an uptick in the rate of inflation is big news because it’s a sign of economic strength that the Fed has been expecting for nearly six years.

Back in 2008, on the brink of the largest financial crisis since the Great Depression, the Fed decided to slash lower interest rates to near zero and began buying large amounts of government debt in a policy called quantitative easing. By increasing the supply of money and making it less appealing to passively save it, the Fed hoped to encourage investment and spending, jump-starting the economy.

And it worked—slowly but surely. By the second half of 2009, the U.S. economy had started to grow again. By last year, the economy was growing at the fast clip of nearly 2.3%. This year, bolstered by the Trump tax cuts, economists expect the economy to grow by 3.2%.

But through years of economic recovery and a rising employment rate, the rate of inflation stayed stubbornly low—puzzling the Fed and making them reluctant to raise interest rates. As 2017 came and went and measured inflation stayed below the target 2% rate for the sixth consecutive year, some economists worried it was a sign of low consumer confidence or proof that growth in wages was being permanently hampered by sluggish productivity growth. The fact that the inflation rate is finally starting to approach the Fed’s target rate means that the economy is shifting into a higher gear.

Why The Stock Market Is Freaking Out

Now that inflation is increasing, all eyes are on the Federal Reserve and its new chairman, Jerome Powell. If the rise in inflation is too fast and furious, the Fed will want to rein it back to the target rate—by increasing interest rates more aggressively than the markets have expected.

This is why the stock market has been spooked by the news. A rise in interest rates will make bonds more attractive, decreasing the relative appeal of stocks. Higher interest rates also make borrowing more expensive for consumers and businesses, which could put a damper on growth.

Currently, the Fed is predicting that inflation will be on track to hit or slightly miss the 2% target in 2018. But they will act to increase rates if inflation exceeds expectations, attempting to toe the fine line between “cooling down” the economy and sending it tumbling back into recession.

The Bottom Line

Our economy is a finely tuned machine. Each component of it—employment, interest rates, fiscal and monetary policies, productivity, investment, and inflation—influences the others. Like a mechanical watch or a V-8 engine, for the economy to hum along at full productivity, its parts have to oscillate in a delicate balance.

The prospect of inflation returning to the target rate means that the U.S. economy is shedding a squeaky wheel that has caused concern and imbalances, like a stock market that has climbed to precipitous heights in the absence of attractive bond yields. Left unchecked, these imbalances could have sent the economy into another recession.

Now, the Fed will have to tread carefully to make sure that inflation doesn’t drag things off course in the other direction and increase to the point where interest rates must rise too fast, heavily dampening growth.

Investors may find it worthwhile to allocate a larger portion of assets to inflation-protected securities like TIPS, or assets like real estate, gold or timber, which have “real” value that isn’t connected to nominal price. Value stocks tend to perform better than growth stocks when inflation is higher—quality companies are better able to pass increased costs to consumers. But you should always consult a financial advisor before adjusting your portfolio.

From the perspective of the individual consumer, the main thing to worry about with regards to inflation is predictability. So long as prices aren’t too volatile and don’t go up too fast, and you can reasonably expect how many dollars a gallon of milk or gasoline will cost tomorrow, a little inflation isn’t a bad thing.