Everyone in the economy is affected by inflation. For long-term savings and borrowing decisions, it is important to recognize inflation. The U.S. has been hit hard by inflation in 2022. Inflation rose to more than 9% in June.
The basics of inflation
Inflation means the increase in prices for goods and services. The purchasing power of money drops as these prices rise. In other words, inflation reduces the value of your money over time.
The inflation rate is expressed in percentages. The U.S. inflation rate fluctuated between 1.6% and 3.8% from 2000 to 2020. Central banks are expected to try and keep inflation within a range of 1-3%.
Although inflation can rise to 3% at any time, it is best to anticipate 3% inflation when considering long-term borrowing or saving.
However, inflation rates in 2021-2022 have been much higher than the targets. This requires adjustments across the economy.
High inflation is usually a sign that there is a weak economy. It can signify a weak economy because it disproportionately affects low-income consumers and raises interest rates for borrowers.
What Causes Inflation
Inflation can be described as a monetary phenomenon. As more money is introduced to the economy, the purchasing power for each dollar decreases. Central banks decide how much money is introduced to control inflation and prevent deflation.
What’s Causing Inflation in 2022
Current inflation is the subject of much debate. People blame corporate price gouging and the Russian invasion of Ukraine for the current high inflation levels.
Despite all the controversy, Fortune says economists agree that there are some causes for the high levels of inflation that have characterized the economy in recent months.
- The pandemic caused consumer demand to shift away from services and goods, leaving producers with little to no choice but to meet the demand.
- The pandemic’s early days saw factory closures, which reduced supply at the same time as increased demand. This drove prices higher.
- Russia’s invasion of Ukraine resulted in a spike in oil prices. This increased both the cost of manufacturing and shipping and also caused an increase in the price of wheat and other commodities.
“Moreover, the U.S. was facing a labor shortage. Many businesses were shut down for months, unable to meet growing demand. A lot of this was due to stimulus payments. When they finally opened, it was.
Meaning of transitory inflation
Temporary means are temporary. If inflation is not expected last, it’s considered transitory.
Economists debated in 2021 whether high inflation was temporary or long-term. The Federal Reserve and U.S. Treasury Secretary claimed that the 2021 inflation spikes would continue, while academic economists believed the rise in inflation would last. Inflation is not temporary, as we are now well into a prolonged period of high inflation rates.
How inflation affects your money
Imagine you have $100 that you can spend on purchases. Instead, you put $100 under your bed for a year. If inflation is 3% that year, the $100 you keep under your mattress is worth 3% less. Inflation means it will only be able to buy $97 worth of goods last year.
Savings accounts that earn interest can help you save more money. You might lose less purchasing power and even gain. Even if you earn only 1% interest, inflation of 3% will still cause you to lose money. To make wealth out of your savings, you must earn more interest than the inflation rate (3%).
Inflation also affects debt. Inflation can also affect your debt. It makes your money less valuable over time. You still owe $10,000 if you borrowed $10,000 10 years ago but have not made any payments. The $10,000 borrowed 10 years ago is now worth less than the amount you used to buy goods and services. (Officially, you are likely paying more than 3% interest on your debt, so your total debt would have increased.
Lenders will consider inflation when granting long-term loans. If inflation is high, you can expect to pay higher mortgage interest and similar if this happens. It can cause financial damage if lenders and borrowers do not anticipate inflation.
How interest rates affect inflation
The Federal Reserve has one of its main functions: to fight inflation. They do this by setting interest rates.
The Fed increases or decreases interest rates to heat up or cool off the economy. Inflation is high when too much money is introduced into the economy. This can lead to higher prices and more demand. The Fed will increase rates to cool down the economy and keep inflation under control.
A wage-price spiral can cause high inflation. Workers will demand higher wages if prices rise too high to be able to buy. This causes more price rises, which, if not controlled, can lead to further wage increases. Hyperinflation could result if the Fed does not cool the economy by raising rates.
Hyperinflation is a situation where inflation rises very quickly. Exemplifying this is post-WWI Germany. The economy spiraled out of control. The hyperinflation caused prices and German Marks to drop in value. A loaf of bread costs 250 Marks to billions. German currency was issued by the government, with bills eventually worth 50,000,000,000,000 Marks. Inflation only got worse with the infusion of money into the economy.
Hyperinflation is very dangerous for any country. There is no way to save money, and there are no sensible ways to lend money that could be of little use tomorrow. Hyperinflation makes it impossible to have normal, healthy economic activity.
Inflation is when the price of goods and services falls. This makes your money more valuable. At 3% deflation, $100 will buy $103 goods next year.
Deflation might seem like a good thing. After all, who doesn’t love lower prices for goods?
Those who sell those goods are the ones to blame. Anyone with any debt will also suffer from deflation. It’s not a coincidence that periods of highest deflation coincide with periods of economic depression. Most economists would prefer moderate inflation to any degree of deflation due to the possibility of economic depression and the pain that debt holders can experience.
Here are the main points to keep in mind when it comes to inflation
- Inflation causes your money to lose its value
- Long-term savings can be made by earning more interest than the inflation rate (typically 3%)
- Creditors and banks will adjust their rates based on inflation.
- Inflation may affect workers when they receive for “cost of living”.
- Inflation in the United States in 2022 will be primarily due to the response to the COVID-19 pandemic.
- The Fed must raise rates to bring down inflation, possibly enough to cause a recession.
There are many facets to this topic. You will find contradicting information everywhere. But if you have a basic understanding of economics, you can cut through the noise to understand what is being said about the economy.
Consumers should be aware that inflation will continue to rise. Even if the peak has passed, it will likely remain higher than the historical average for a while. As the Fed tries to control inflation, expect high-interest rates and a possible economic recession in the short term.