What Is Inflation—And Why Is Everyone Talking About It?

James Bayard |
Categories
Education

Climbing commodity prices, enormous government spending packages, and the subsequent economic slowdown have resurrected a dormant fear: high inflation. But what is inflation, and is it something to worry about? Much of the thinking surrounding inflation has changed over the years. Economists disagree on what causes it and how much consideration the government and Federal Reserve should give when setting fiscal and monetary policies. Here's a closer look:

What is inflation?

Inflation refers to a general increase in the price of goods and services, which means each dollar in your pocket has less purchasing power over time.

Inflation in a growing economy is expected. The price of some commodities such as coffee, for example, rises steadily, and we expect it to continue. Most economists believe a small amount, around 2%, of inflation is necessary. If an economy is not using all of its labor and resources to produce as much as it can, then a little inflation theoretically boosts productivity. That's because more money spurs more buying, and more buying spurs more production. The Federal Reserve, which is responsible for monetary policy in the United States, has targeted an average annual inflation rate of 2%.

However, high inflation, which causes a devaluation of the currency, creates economic problems for households and markets, including:

  • A drop in real wages. When prices rise more quickly than wages, real incomes drop.
  • Economic uncertainty. When businesses don't know what future costs will be, they make fewer capital investments, slowing down the economy.
  • Less competitive domestic goods. Runaway inflation can cause the nation's consumers to buy more imported goods and foreign consumers to buy fewer of the country's exports.
  • Rising unemployment. As prices increase, businesses may try to reduce costs by employing fewer people.

The Federal Reserve often tries to curb inflation by raising interest rates, but doing so comes with economic consequences. Namely, the cost of borrowing rises, leaving consumers with less money to spend. In return, businesses lower prices to attract buyers. Though this can slow inflation, a drop in consumer spending can also slow down the economy, perpetuating one of the adverse effects of high inflation. 

Should we worry about rising inflation?

As the economy reopens, inflation has sped up. Economists disagree over whether that's cause for alarm, and that's because the last few decades have challenged the conventional wisdom on inflation.

Low unemployment rates have historically been associated with high inflation, although this link deteriorated in the late 1980s. And following the 2007-2009 Great Recession, inflation remained almost obstinately stable against fast job gains. While some economists see big government spending, low interest rates, and post-pandemic American consumers eager to spend as a recipe for disaster, others are less concerned.

The reasons they give are varied. Stable inflation over the last few decades may signal that central banks have mastered monetary policy, though not likely in my opinion, making it less likely for inflation to get out of control. Perhaps the current spike in inflation will be a temporary issue, as the economy snaps back to pre-pandemic levels of activity and supply chain issues are worked out. Some argue that even if high inflation represents a real economic risk, the risk of keeping so many unemployed and without economic relief is far greater.

Inflation is a fact of modern economic life. When it's kept below a manageable threshold, it can be a good thing. It's hard to predict what the economy will look like as countries open up. However, you can expect that inflation will remain a hot topic of discussion as the economy finds its post-pandemic footing.

SOURCES:

What Happened to the Phillips Curve in the 1990s in Canada? (bankofcanada.ca) (US information included)

Explaining the inflation puzzle (brookings.edu)

The Fed - Why does the Federal Reserve aim for inflation of 2 percent over the longer run?

Americans' inflation fears reach a new high after consumer prices jump (cnbc.com)

Inflation: Investors are concerned; economists see a sign of temporary growth (cnbc.com)