Inflation impacts everyone in the economy. It’s important to understand inflation for long-term saving and borrowing decisions. Inflation has hit the U.S. hard in 2022, with inflation surges to over 9% in June.
Basics of Inflation
Simply put, inflation refers to the rise of prices of goods and services. As these prices go up, the purchasing power of money decreases. So essentially, inflation makes your money worth less over time.
The inflation rate is expressed as a percentage. From 2000-2020, the U.S. inflation rate has fluctuated between 1.6 and 3.8 percent. Typically, central banks will try to keep inflation in a target range of 1-3%.
While inflation can be higher than 3% at any given time, it’s traditionally been best to plan for 3% inflation when thinking about long-term borrowing and saving.
Of course, 2021-2022 has seen much higher inflation rates that are far above those targets. This is requiring adjustments throughout the economy.
Typically, high inflation is a sign of a weak economy. It disproportionately impacts low-income consumers, raises interest rates for borrowers, diminishes everyone’s purchasing power, and can lead to economic recessions.
What Causes Inflation
Inflation is a monetary phenomenon—as more money enters the economy, the purchasing power of each dollar decreases. Central banks control how much money is introduced to influence the rate of inflation and to prevent deflation (more on that below).
What is Causing Inflation in 2022?
There is a lot of debate about the cause of current inflation. People have blamed things like the Russian invasion of Ukraine and corporate price gouging for current high rates of inflation.
Despite all the controversy, according to Fortune, economists generally agree on some of the causes behind the high inflation that has defined the economy over the last several months:
- The pandemic shifted consumer demand away from services toward goods, which left producers unable to keep up with demand.
- Factory closures from early in the pandemic reduced supply just as demand was rising, which sent prices up even further.
- Russia’s invasion of Ukraine caused a spike in oil prices, which increased the cost of both manufacturing and shipping, while also forcing up the price of wheat and other commodities.
On top of that, the U.S. was dealing with a labor shortage, leaving many businesses that had been shuttered for months unable to meet rising demand — much of which was due to stimulus payments — when they were finally able to open.” (yahoo.com)
Transitory Inflation Meaning
Transitory simply means temporary—if inflation is not expected to last, it is considered transitory.
In 2021, economists debated whether high inflation would be transitory or long-term. Academic economists argued that the spike in inflation would persist, while the Federal Reserve and U.S. Treasury secretary claimed the inflation surges of 2021 were transitory. Considering inflation has gotten ever higher through the first half of 2022, it’s clear now that inflation was not in fact transitory and we’re well into a long stretch of high inflation rates.
How Inflation Affects Your Money
Say you have $100 you can use to make purchases. Instead, you keep that $100 under your mattress for a year. If the inflation rate is 3% that year, then the $100 you held on to is worth 3% less—because of inflation, it will only buy $97 worth of goods in last year’s dollars.
If you put that $100 in a savings account that earns interest, you lose less purchasing power, and might even gain, depending on the interest rate you’re earning on your savings. If you only earn 1% interest, you’re still losing money if inflation is 3%. For you to actually gain wealth from your savings, the interest rate you earn must exceed the rate of inflation (3% in this case).
Debt is affected by inflation as well. If inflation makes your money worth less over time, it also makes your debt smaller. If you borrowed $10,000 10 years ago and made no payments since, you still owe the same amount in nominal dollars. But the $10,000 you borrowed 10 years ago will buy you fewer goods and services today than it used to. (Of course, you’re probably paying over 3% interest on your debt, so your total debt level would have gone up.)
Lenders will plan for inflation in the terms of a long-term loan, so if inflation is high, you can expect to pay more in interest on mortgages and the like. If inflation differs greatly from what lenders and borrowers anticipated, it can cause financial harm.
How Interest Rates Affect Inflation
One of the Federal Reserve’s main functions is to combat inflation. The primary way they do this is through the way they set interest rates.
The Fed raises or lowers interest rates to heat up or cool down the economy. If inflation is high, the economy is overheated—too much money has been introduced, leading to higher prices and increased demand. The Fed will raise rates to cool the economy down and bring inflation under control.
A big risk of high inflation is a wage-price spiral. If prices go up too much, workers demand higher wages to be able to afford purchases. This leads to even more price increases, which, if unchecked, lead to even more wage increases. If the Fed doesn’t cool down the economy with higher rates, we could end up with hyperinflation.
Hyperinflation occurs when inflation increases very rapidly. An example is post-WWI Germany. The economy spiraled out of control. Hyperinflation caused prices to soar—and German Marks were worth less and less. During the course of 1923, a loaf of bread went from costing 250 marks to billions of marks. The German government issued new currency, eventually printing bills worth 50,000,000,000,000 Marks! Naturally, this infusion of new money in the economy only caused inflation to get worse.
Times of hyperinflation are very dangerous for a country. No one will save money, and no one sensible would lend money that might be worthless tomorrow. Normal, healthy economic activity is impossible during hyperinflation.
Deflation is the opposite of inflation—the price of goods and services goes down. This makes your money worth more; at 3% deflation, the $100 under your mattress will buy $103 worth of goods next year.
You might think deflation could be a good thing—after all, who doesn’t like lower prices for goods?
The sellers of those goods, that’s who. Also, anyone who carries any debt will suffer under deflation. And it’s no coincidence that our periods of greatest deflation coincide with economic depressions. Because of the potential for economic depression and the pain caused to debt holders, most economists prefer modest inflation to any amount of deflation.
The main things to remember with regard to inflation:
- Inflation makes the value of your money decline
- For long term savings, it’s best to earn more interest than the rate of inflation (typically 3%)
- Banks and creditors will adjust the rates they charge based on anticipated inflation
- Inflation may also impact “cost of living” pay raises for workers
- The primary cause of inflation in the U.S. in 2022 is the stimulus response to the COVID 19 pandemic
- To bring inflation under control, the Fed will have to raise rates, potentially high enough to trigger a recession
There are a lot of nuances to the topic, and you will find conflicting information everywhere you look, but if you understand the basic fundamentals of economics, you will be able to cut through the noise and interpret what you are being told about the economy.
For consumers, it’s best to be prepared for inflation to remain high; even if we’ve seen the peak, it’s likely to stay higher than the historical average for some time. Expect high interest rates and quite possibly economic recession in the near term as the Fed works to bring inflation under control.
The threat of recession should make you focus on your personal finances. Keep your budget under control, reduce debt, and establish an emergency savings fund if you don’t already have one. As always, you can contact us at credit.org for free debt counseling any time.