What is Inflation, Really?

Inflation is the rate at which prices for goods and services increase over a certain period.

For example, the price of a gallon of milk has increased 10 times, from 36 cents to $3.60, in the span of 100 years from 1913 to 2013 in the United States. Prices are set based on supply and demand, but the rise in prices is due to other economic factors at work. One of these is inflation. But what does it mean?

The inflation rate essentially indicates the decline in the purchasing power of your money, i.e. how much stuff you can buy with a given amount of money. Per the latest Consumer Price Index (CPI) published by the Bureau of Labor Statistics, the annual inflation rate in September 2020 was 1.4%, which implies that a basket of goods and services that cost $100 in September 2019 now costs $101.40. It is worth pointing out that inflation is the phenomenon of an overall increase in the prices of goods and services, rather than an increasing trend in the price of a specific commodity.

Types of inflation:

  • Demand-pull inflation
  • Cost-push inflation

Examples

While a gradual increase in prices over the years is normal and expected, inflation gone unchecked can lead to hyperinflation, which is when a price level rises more than 50% per month (Cleveland Fed). Modern history offers some drastic instances of hyperinflation.

  • Germany: After losing World War I, Germany was expected to make hefty reparations as well as pay off huge amounts of debt it had incurred for war efforts. To obtain foreign currencies to meet these obligations, the German government was forced to sell marks at any price possible, devaluing the currency significantly. At its worst, Germany’s inflation rate was 29,500 percent
  • Venezuela: Venezuela’s case serves as a recent reminder of the negative impact of a government’s unchecked power to print currency. This is what led to the country’s 65,000 percent inflation rate in 2018.
  • Zimbabwe: In November 2008, Zimbabwe’s inflation rate was 79 billion percent, a time during which one loaf of bread cost about 35 million Zimbabwe dollars.
  • Hungary: World War II ravaged Hungary’s economy, which resulted in its inflation rate reaching 13.6 quadrillion percent at its highest.

Fed inflation targeting policy change

The Federal Reserve is expected to promote maximum employment, ensure price stability, and moderate long-term interest rates. As a means to achieving its goal of price stability, the Federal Reserve engages in inflation targeting to keep prices low and predictable in the US economy.

In 2012, the Fed declared that it considered an inflation rate of 2% as measured by the Personal Consumption Expenditures (PCE) price index to be just right – not lower, not higher – to meet its price stability mandate. If inflation were to exceed this target, the Fed might raise the target federal funds rate to rein in inflation. If inflation were to run too low, the Fed might lower the target federal funds rate to help boost inflation. As seen in the graph below, inflation has been consistently below the 2% target rate in the recent past. At the same time, this pandemic has been putting more pressure on inflation which could further hamper economic activity. To stimulate the economy, the Fed had already lowered its target federal funds rate to a low range of 0-0.25%. Lowering the Federal funds rate any more, below the effective rate, to keep up with its previous inflation targeting policy would be unrealistic and would render the Federal Reserve unable to boost the economy any further through interest rate changes.

To avoid such a situation from arising, the recent change in the inflation targeting policy implies that the Federal Reserve would allow inflation to run moderately above 2% for some time and shift to an “average inflation targeting” approach – where the inflation rate averages to 2% over the long run. By maintaining room for potential interest rate cuts, the threat of lower inflation expectations can be avoided and the public will continue to contribute to the economic activity in the country.