Inflation for dummies!

Inflation.... this the most sought after word in the Federal Reserve today. Janet Yellen and her governors are craving for inflation ever since they publicly annonced their intentions to raise the interest rates following the FOMC meeting in August, 2015. However, inflation today has been stubbornly low, in spite of money pumped into the economy. Let's take a look into what is inflation and what are the pitfalls.

Inflation by definition is a persistent and substantial rise in prices related to an increase in the volume of money. This also results in the loss of value of currency. When this happens, it's when stuff costs more. Whether it is a shiny new car or that new iPhone that you sooooo desire.

Typically, inflation is often misunderstood and villified. Let's start with how it is measured in the first place. The government has a shopping list of 80,000 items and services (for true!!).It collects the data on the prices of these items every month. It then averages and weights these prices using various formulas. The result is a number called Consumer Price Index (CPI). It is also sometimes referred to as Retail Price Index (RPI). The CPI is a measurement of how much stuff costs us. Currently, it is at 246. You can learn more by clicking here.

SO the general feeling is inflation is bad, because we don't want to pay more for stuff. Fair point. However, it depends on our situation. Let's look at a couple of scenarios.

Scenario 1:
Let's say you have $100 under a mattress. After one year, with a inflation rate of 3%, it will be worth $97. So, essentially your purchasing power has gone down.

Scenario 2: 
Let's say you invest that $100 in an investment with a 4 percent return. So in year from now you will have $100 + $4 = $104. However, since inflation has gone up by 3 percent, it will be worth $104 - $3 = $101. The real rate of return is only 1 percent

Scenario 3: 
Let's say you take a loan from a bank for $100 at a fixed interest rate of 2%. Hence, after one year you owe the bank $100 + $2 = $102. However, it will only be worth $99 due to three percent inflation. Hence, inflation has paid $1 of your debt.

Hence, if you owe money to an entity, inflation can be used to one's advantage. However, too much inflation is also not good. In the event of increased inflation, uncertainty about what will happen makes corporations and consumers less likely to spend. This hurts economic output in the long run. Lenders are less likely to make loans if they cannot accurately adjust rates to make up for inflation. Those with pensions or fixed income see a decline in their purchasing power and, consequently, their standard of living. If the inflation rate is greater than that of other countries, domestic products become less competitive.

In the event inflation gets really bad, people hoard tangible items as a way to shed excess cash before it is devalued. This creates shortages of the hoarded items. Hyperinflation can occur when a currency loses its value so rapidly that the very concept of currency becomes meaningless, such as the issuing of 'trillion dollar bills'. This often results in a complete breakdown of the economy.

So, does it mean we need to avoid inflation by all costs and measures?  Not necessarily. A modest amount of inflation is a sign of growing economy. To avoid inflation investors often convert assets from money to capital projects, creating more growth.

In the next post, we will learn more about the types of inflation and the tools available to combat inflation.