12 September 2022

Inflation, CPI, and What it All Means

Unsure of what inflation and the CPI are? This blog explains it all in layman's terms.



Inflation, CPI, and What it All Means


    What is inflation?

    What Causes Inflation?

    Consumer Price Index (CPI), or How We Measure Inflation

    Pros of Inflation

    Cons of Inflation

    Wrapping Things Up

In economic discourse, inflation has a permanent seat at the table. It sits there, often uninvited and unwanted, and makes a mess of things. It is the bane of consumers, the source of uncertainty for businesses, and the reason for sleepless nights for central bankers.

But what is Inflation? What causes it? What are its effects?

What is inflation?

Inflation is often defined as an increase in the prices of a basket of goods and services over time. Inflation is why your grandfather paid ten cents for an ice cream cone, but you now might pay $8. It's the reason why things seem to cost more and more as the years pass. But you're not imagining things — they actually do. Why? Because of Inflation.

What Causes Inflation?

Several things cause inflation, and there are also myriad types. Let's briefly dive into each one:

  1. Demand-Pull Inflation: One of the more well-understood types, demand-pull inflation describes the phenomenon of an increase in demand for goods leading to an increase in prices. It can result from population growth, rising incomes, and expansionary monetary policy. "Too much money chasing too few goods."
  2. Cost-Push Inflation: Another well-known type of inflation, cost-push inflation, is more frustrating to deal with as its root causes are less well understood. Cost-push inflation is caused by a "rise in costs of raw materials and labor." Because it becomes more expensive for companies to produce, their aggregate supply decreases, passing the cost on to consumers through higher prices.
  3. Built-In Inflation: As cost-push and demand-pull inflation lead to price hikes, individuals will begin to demand higher wages to keep up with their living costs. If a company is unwilling to pay for the increased demand, its employees will find employment elsewhere. As corporations accommodate their workers' wage desires, they will try to recoup some of the lost profit by increasing the price of their products.

Consumer Price Index (CPI), or How We Measure Inflation

The Consumer Price Index (CPI) measures the average price change that consumers pay for a basket of goods and services over time. The CPI includes food and beverages, transportation, apparel, medical care, education, and more. We use CPI to calculate inflation because it's a comprehensive measure that captures the prices of most of what consumers buy.

But the CPI isn't perfect. For example, missing in the calculation are housing costs, investment products, and costs of leisure. Moreover, because the CPI is so broad, it tends to ignore these specific price changes. As a result, during times of larger-than-desired inflation, price pressure may feel more intense than the CPI indicates.

Pros of Inflation

It might seem odd that inflation comes with benefits, but a little inflation can be good for an economy.

Economic growth: A moderate rate of inflation (2-3 percent) is often linked with economic growth. That's because a higher CPI means that businesses have an easier time increasing prices, which leads to increased profits and more money to reinvest in the business. This, in turn, can lead to more jobs and higher wages.

Reduce unemployment: A little inflation can help reduce unemployment because when prices rise, people are more likely to seek employment as they expect their wages to increase along with the cost of living.

Good for debtors: When prices rise, the real value of debt decreases. So, if you have debt, inflation can work in your favor as it lessens the amount of money you need to repay.

For wages, there's a big caveat here: real wages need to be growing at the same rate as inflation or faster. If not, then workers are falling behind. In 2022, wage increases have trailed inflation, from under 4 percent to 9-plus percent. So while wages do increase in times of high inflation, over the long term, they rarely keep up.

Cons of Inflation

The cons of inflation are as varied as they are numerous. Here are a few of the biggest complaints:

Purchasing power: As prices increase, each dollar you have buys less and less. So, while you may be bringing home the same wage, your standard of living is slowly declining as inflation eats away at your earnings. And as discussed, wage increases rarely keep up with inflation over the long term.

Retirement and savings accounts: Inflation is especially hard on seniors, as it slowly chips away at the purchasing power of their retirement and savings accounts. Because these sources of income are often fixed, they don't increase with inflation. This leaves seniors struggling to make ends meet as the cost of living rises.

Investment risk: When inflation is high, the prices of investments like stocks and bonds can become volatile. This makes it difficult to predict what will happen to your investment portfolio and can lead to significant losses if you're not careful.

Bad for savers: Whileinflationn can be good for debtors, it's not so great for savers. That's because when prices rise, the money in your savings account is worth less and less. So, if you're someone who likes to keep their money in cash, inflation can be a real problem.

Wrapping Things Up

The causes and effects of inflation aren't so cut-and-dried; they tend to make themselves more obvious in retrospect, sometimes years after the fact. That's why, for monetary policy-makers, inflation is such a tricky beast to tame. It's a constant game of catchup, anticipation, and second-guessing.

In 2022, we're currently in the highest period of inflation in the past 40 years, a historic event affecting everyone, from wage-earners to retirees. This isn't just in the United States; it's worldwide and likely to continue for the foreseeable future.

So what can you do? The best defense against inflation is to be prepared. Keep an eye on the inflation rate and, if possible, adjust your budget accordingly. While we can't provide investment advice, it's worth learning about assets with a history of outpacing inflation, such as stocks, real estate, precious metals, and, of course — bitcoin.

Please be aware that: Cryptocurrencies are unregulated in the UK; Cryptocurrencies are not protected under Financial Ombudsman Service or Financial Services Compensation Scheme (FSCS); Profits may be subject to capital gains tax; The value of investments can go down as well as up.

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