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What is Inflation? And Why Should You Care?

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One of the topics that we have heard a lot about as the economy lurches slowly toward recovery is inflation. But what is inflation? We hear about all sorts of incarnations of inflation, from core inflation to stagflation. While getting into the nuts and bolts of inflation can be a complex exercise, some general knowledge about inflation can help you learn a little bit more about a very real force that can have a very real impact on your finances.

As you listen to monetary policymakers talk about inflation, and as you read about changes to the CPI, it helps to have a general idea about what is going on. That way, you will be prepared to make more informed decisions about what to do with your money.

The Basics: What is Inflation?

At its most basic, there isn’t really a big secret to inflation. Basically, inflation is a reduction in your spending power. As prices rise, your money buys less than it used to. Of course, the theory is that wages go up as prices rise, too, so you are still supposed to be able to preserve your earning power. Unfortunately, that theory doesn’t always hold true. Some economists point out that wage stagnation over the last couple of decades has contributed to a situation in which prices keep getting higher — but household incomes aren’t able to keep up.

One of the terms that some employ to describe the disconnect between inflation and economic growth is stagflation. One economic theory (and there are quite a few, many of them debatable) is that prices rise in response to economic growth. However, if prices are rising and the economy is growing at a snail’s pace, many call that stagflation. Some are convinced that we are headed right toward some serious stagflation, since the economy isn’t growing very much while energy costs rise and food inflation affects more household budgets.

Measuring Inflation: CPI and Core Inflation

So, how do we measure consumer inflation? We know that inflation is a rise in prices, but how do we tell the rate at which prices are rising? The government uses various measures to determine this, but two terms you are likely to have heard are CPI and core inflation.

CPI: This stands for the Consumer Price Index. It is a basket of prices for a wide variety of goods and services. Every month, tens of thousands of prices on products and services are compiled and averaged into the index. These items are categorized with different labels, including transportation, food, energy, medical, education and more. The CPI is generally used as a gauge of how quickly prices are rising.

Core Inflation: The government, in order to get a more “accurate” view of “overall” trends, breaks out more volatile elements of CPI: food and gas prices. This means that when the government makes monetary policy based on inflation rates, it doesn’t include food prices and fuel prices. Some argue that this means that monetary policy is being made based on a measure that doesn’t include some of the items that have the greatest direct impact on households.

Why You Should Care

Obviously, you should care because it’s your purchasing power being eroded by inflation. Your hard-earned dollar won’t buy as much in 10 years as it bought 5 years ago. You are probably already noticing this as packages get smaller and as prices rise. Some, instead of telling you to base your financial planning on government measures of inflation, advocate looking at your personal inflation rate.

You can do this by adding up what you spend on certain items each month, and then track trends in your own household spending. You can then adjust your personal economy’s monetary policy based on what you find.

What do you think of inflation measures? And how do you plan to beat inflation so that it doesn’t erode your purchasing power?

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18 Responses to “What is Inflation? And Why Should You Care?”

  1. mannymacho says:

    It is really interesting how many of the younger generation have not been exposed to serious inflation, and therefore do not understand it. In the 80′s you didn’t have to teach someone what inflation was.

    • billsnider says:

      Try the 70′s. We had double digit inflation for three years. Nixon imposed wage and price controls. Worked only on wages.

      On CPI, there are a lot of things that are not included. Things such as your car insurance, tax increases, incremental tax rates as wages rise, social security tax increases and so forth. They are killers.

      Bill Snider

      • Shirley says:

        Yes, the 70s were definitely rough financially, but many of us came away with some well learned lessons that have perhaps made us more financially stable today.

        Those ‘not included’ things on the CPI are things often overlooked by inexperienced young people… until their wallet takes the hit.

  2. freeby50 says:

    First of all there is no “core inflation” defined by the government. THey don’t have such a term. What they do have is the CPI excluding food and energy. But that measure is not really used for much of anything. They have many many different indexes. The main inflation measure is the CPU for all items which is what they use to adjust spending.

    “This means that when the government makes monetary policy based on inflation rates, it doesn’t include food prices and fuel prices.”

    How? I don’t believe this is correct.
    There are NO laws or spending programs that use the inflation measure that excludes food and fuel.

    ref :
    http://www.bls.gov/opub/focus/volume1_number15/cpi_1_15.htm

    • uclalien says:

      I feel the need to stand up for the author here. Based on the fact that she uses the terms “monetary policymakers” and “monetary policy,” it’s obvious she was talking about the Federal Reserve. The Fed uses core inflation to target its preferred inflation rate (believed to be roughly 2%).

      And unless I missed it, the author never discusses government spending programs (fiscal policy), which is very different from monetary policy.

      Perhaps you can’t find an inflation measure called “core inflation” because its a general term that refers to a type of index (as your link indicates). The core inflation measure that the Fed prefers is the PCE price index, which is prepared by the U.S. Bureau of Economic Analysis. I feel the need to add that the simple fact that the government calculates an index doesn’t necessarily make it any more accurate or valid than a non-government created index.

      And if we are in a correcting mood, I believe you are referring to CPI-U (“Consumer Price Index – All Urban Consumers”), not CPU (“central processing unit”).

      • freeby50 says:

        Honestly I don’t think thats what she meant. If she was talking about the Feds use of PCE then why is there no discussion of any of that??

        There is NO mention in the article at all of PCE, BEA or the Fed. Yet the CPI is all over the article. I think its clear that she’s talking about CPI specifically.

        If she meant PCE than she really should have said so and explained whats what. Otherwise its just very confusing and it looks like she is claiming CPI less gas/food is used to set monetary policy which we know is not correct.

        I wasn’t aware the Fed used a different inflation measure. Thanks for pointing that out. You learn something new every day.

        CPU was a typo, threes no edit function here or I would have corrected that.

        • uclalien says:

          The author’s repeated references to monetary policy can only be interpreted as a reference to the Fed’s actions. By definition, that’s what monetary policy is.

          She probably didn’t mention PCE because virtually everyone refers to such measures as simply “core inflation.” I understand how the way she words it could be a little confusing though.

      • Miranda says:

        Thanks uclalien! You’re right; I should have said when the Fed sets its monetary policy rather than the government. Because the Fed makes all sorts of references to what it considers core inflation when setting its benchmark rates and making economic policy. I probably should have been clearer about that, since the Fed’s status as government is murky. Here’s an interesting speech from Mishkin on headline inflation, core inflation and central banks: http://www.federalreserve.gov/newsevents/speech/mishkin20071020a.htm

        • uclalien says:

          I don’t consider the Fed’s status as “government” as murky at all. The Board of Governors, including Chairman and Vice Chairman, are appointed by the President and confirmed by the Senate. That’s enough for me to believe it’s perfectly reasonable to remove the “quasi” from “quasi-government agency.” Add the fact that the Fed was created by and answers to Congress, and there’s no doubt that the Fed is “government.”

  3. uclalien says:

    “Some economists point out that wage stagnation over the last couple of decades has contributed to a situation in which prices keep getting higher — but household incomes aren’t able to keep up.”

    A few comments regarding wage stagnation:

    1) Between 1997 and 2009, real wages were virtually flat. We need to keep in mind that 1997 was in the middle of the dot-com bubble, whereas, we are currently in the middle of the worst economic downturn since the Great Depression, so I’m not sure it’s an apples to apples comparison. In any case, the median household is as wealthy as it was in the middle of major economic bubble (I would argue today’s median household is wealthier for the reasons listed below).

    2) Wage measures that show stagnation generally do not include fringe benefits, which have increased dramatically over recent decades.

    3) The inflation adjusted price of virtually all products, including food, is far lower than at any time in history. And despite the recent run-up in gas prices, even the inflation adjusted price per gallon of gas is currently near its 100 year average, despite the fact that roughly 15% of that price is taxes, which didn’t even exist until the 1950s and only $0.02 at that time. In other words, what we see as astronomically high gas prices are about average historically and near their historic lows when taxes and inflation are removed from the equation.

    Here are some fun links that hit on this topic from a blog I read on occasion:

    a) http://mjperry.blogspot.com/2010/12/magic-and-miracle-of-marketplace.html

    b) http://mjperry.blogspot.com/2011/02/for-some-products-prices-have-been.html

    c) http://mjperry.blogspot.com/2011/02/time-cost-of-food-has-fallen-since-2008.html

  4. govenar says:

    It seems like this doesn’t answer the most basic question: why do prices go up?

    • uclalien says:

      It does seem like a simple question, but it can get rather complex.

      The simplest and most ambiguous answer is supply and demand. A larger supply of money (including credit) will generally push prices higher. In addition, increased demand and/or decreased supply for individual product will also push the price of that product higher.

      Note: When I say increase and decrease, I’m talking about relative changes in supply and demand. Without getting too deep into the economic weeds, in some instances, demand for a product can increase, but prices can still decrease if additional supply is large enough to offset the increase in demand. There’s also the issue of elasticity, but I won’t get into that here.

  5. Strebkr says:

    I used to think inflation wasn’t real. Then I grew up and saw how fast prices really go up. It really does erode the value of a dollar.

    • Shirley says:

      LOL… that makes me think of my dad saying, ” Five dollars?! I remember when a hamburger was 15 cents!

      Thanks for the morning grin. ;-)

      • Strebkr says:

        My parents have made comments like those from time to time. I always laugh when I hear them. I think its bad that I am starting to have my own stories. Like the time I was 16 and gas was under $1 a gallon. It was the only time I ever saw that.

  6. Mark says:

    You are all missing the basics. True inflation is increasing the money supply.
    This is done by easy credit.
    The extra money can go anywhere stocks, houses, commodities. It seems foolish to only look at the narrow CPI, PPI, etc. since all forms of inflation are bad. It makes unfair winners and losers. If houses go up, owners benefit but buyers lose out. You cheer when gas prices drop, but not housing prices. I would prefer stable prices or lower prices based on productivity improvements.
    The government benefits the most from inflation since it is a hidden tax increase, without the pain of debate.


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