According to opinion polls, inflation is the number one problem in the country. This is understandable. According to the latest data, inflation last year was 7.5%. In the 21st century, annual inflation was above 3% only four times, and never rose more than 4% compared to last year.
In this column, I will answer a few questions about inflation. Hopefully my answers will help you understand what inflation is, how it affects you and what can be done to mitigate the effects of inflation.
What is inflation?
Inflation is the average increase in prices for ordinary products and services we purchase. Changes in prices for products and services that are more important to our budgets, on average, gain more weight. Inflation is usually expressed as an annual percentage rate. Thus, inflation of 7.5% means that the weighted average cost of goods and services for the year increased by 7.5%.
Why are we worried about inflation?
Inflation increases the cost of living. If your income rises below the inflation rate, then your standard of living is falling. So if your income has grown by less than 7.5% in the last year, then economically you are lagging behind.
When was the last time inflation was as high as it is today?
In 1981, inflation was 10.3%. In 1980 there were 13.5%
Are there high inflation rates in other countries today?
Yes, some countries are experiencing higher inflation rates, such as Germany and the UK at almost 6%, Mexico at 7% and Russia at almost 9%. But at least we are lower than the inflation rate of 77% in Cuba and the recent inflation rate in Venezuela of 472%.
What caused the jump in inflation?
There are two reasons. First, these are ongoing problems with the “supply chain”. It just means that delivering many products on the shelves of sellers takes more time. In addition, the constant shortage of workers has a negative impact on the availability of certain services. The low supply of many products and services means that those that are available are more expensive, leading to higher prices.
The second reason was the result of generous federal incentive programs over the past two years. In 2020 and 2021, the federal government has allocated more than $ 5 trillion to various programs to help households, businesses and institutions survive the pandemic. As a result, there is money to be spent. As consumers try to spend money on a limited number of products and services, their actions put additional pressure on price increases.
Can’t the government just control price changes?
Forty years ago, the federal government introduced price controls to deal with a similar situation with inflation. As a result, two problems arose. Changes in prices serve as signals that tell firms how to adjust production to eliminate both surpluses and deficits. Price control eliminates this important feature. In addition, some firms used schemes and even fraud to circumvent controls. When price controls were lifted, inflation tripled.
Some argue that increased government spending will lead to lower inflation. Is that true?
Government spending, which increases the supply of products and services, encourages more people to work and makes workers more productive, moderately rising prices. However, many of these programs take time to work, so the impact on inflation does not happen immediately. A good example is the educational and training efforts aimed at improving the productivity of current and future employees.
Then what can the government do to curb inflation?
The government agency that can have the fastest influence is the Federal Reserve System (“Fed”), which is the country’s central bank. To reduce inflation, the Fed will want to cut consumer spending. The Fed will do this by raising interest rates – thus making it more expensive for people to borrow and spend money – as well as withdrawing cash from the economy.
Are these actions guaranteed to work for the Fed?
The Fed certainly has the tools to slow the economy and reduce inflation. The problem is that their actions could put the economy in reverse – it means a recession. That was forty years ago, when inflation was double-digit. The Fed was able to reduce inflation from 13% to 3% in three years, but the cost was two recessions in those three years.
How will these actions affect investments?
As a rule, the stock market reacts negatively to rising interest rates. The exception is when equity investors expect higher interest rates to quickly dampen inflation. However, if stock market investors expect the Fed’s actions to lead to a recession, stock prices are likely to fall.
Inflation has not caused much trouble in the economy for four decades, so many people have witnessed the debate on inflation for the first time. Hopefully my questions and answers will help you decide how to respond to the ongoing inflationary battle.
Mike Walden is an Honored Professor of Reynolds at the University of North Carolina.