Lesson 18 Inflation

The posts in my blog space named “lessons” are meant to provide some background on concepts I throw around like fish at a Seattle fish market. Some of my readers are not economists, and they often send me emails requesting that I try to better explain macro concepts. I sometimes direct them to my online resource called MacroNotes (http://macronotesmba.com/ ) but that’s a little like sending someone who wants to taste a little pho to Hanoi when our local Vietnamese restaurant, Rush Hour Station, has perfectly good pho. So instead of going to MacroNotes for more information about inflation ( http://macronotesmba.com/lessons/inflation-and-unemployment/ ), I will post today on that topic.

Inflation isn’t an easy topic and therefore deserves some attention. And inflation is a very important topic these days for several reasons. First, it is growing slower in the USA and that makes us wonder about it. Second, it seems to be associated with economic growth forecasts that are less than rosy. Something is going on out there that makes lower inflation a sign and maybe even a cause of slower economic growth. And third, our policymakers see the lower inflation rates as a reason to keep pouring fuel on the economy.

Inflation will never be as exciting as a Confederate War Memorial or an Indiana University football game, but inflation is pretty interesting these days. So what is inflation?

Let’s begin with this definition: inflation is the rate of change of prices. For you math buffs, this definition is basically an equation. I can talk about the inflation rate of weed prices in Colorado. Suppose a sack of weed went from $2.00 to $2.20 in the last month. Applying the formula, we can say that the inflation rate of weed during that time period was 10%. Anything that has a price has an inflation rate associated with it.

Applying this concept of a rate of change means that inflation of something could be positive, negative, or zero. If it is negative then we call that deflation as it means prices are falling. If the calculation is positive then we simply call that inflation. If the calculation is zero we have no name for that. We would say inflation is zero. Once a teacher called me "zero" but that had nothing to do with inflation. 

We also have terms to describe how the inflation rate is changing over time. If the inflation rate goes from 2% to 1% we say inflation in decreasing or we say we call this disinflation. A rising inflation rate is called reflation.

The inflation rate we are discussing today is the inflation rate of a nation. In the USA each day, we not only buy weed but we buy silly things like cars and doctor visits and Uber rides. Our Labor Department defines someone called the typical Urban Consumer. Let’s call her Jaden. Jaden buys stuff each month at Target, Kroger, and of course Amazon. Since she is the typical Urban Consumer, the Labor Department tracks what she pays for all the goods and services she buys. She hides this information from Chuck but that is another story. 

The idea is that the Labor Department can get a number that represents what she paid for all the stuff she bought in any month, say for example, December of 2016. We would call that number the CPI for December 2016 for the USA. Let’s say that number is 200. We collect that same price information in January of 2017. Suppose the number for January turns out to be 210. We would use our formula and conclude that the inflation rate in January was 5%. If that rate kept up for every month in 2017, then we would say the annualized rate of inflation in January was 60%. But the inflation probably won’t keep up at that rate and the 60% is just a way to express what happened in one month.

Suppose you don’t spend exactly like Jaden. Perhaps you really like Cuban black beans and you eat that with rice a disproportionate number of times per day. Aside from certain gastrointestinal issues that we won’t cover here, your own personal inflation rate might be different from the national rate. But us macro people do not care about you – we are more interested in how much the average of all of us is paying for goods and services. So when you read something about the CPI in the USA you need not feel concerned about your own cost of living, as it tells you only about the cost of living of the average person.

The CPI is not the only measure of prices in the USA. So sometimes you will hear about inflation as measured by the Personal Consumption Deflator or the GDP Deflator. Maybe you will read about Producer Prices. The truth is that there are many indicators of inflation but here is the main takeaway. For most of us, the CPI is just fine. And second, while the others are different in various ways they usually tell a similar story about inflation.

One more fun fact. Food and energy prices are notably erratic. They bounce around like a 4-year-old in a bounce house. To get a better reading of all prices, the Labor Department publishes the CPI without food and energy prices. If you are trying to understand the general trend of all prices over time, this CPI Less Food and Energy is your baby. Finally, stocks and bonds and other financial assets are not goods or services -- and therefore the prices of these assets are not included in the usual measures of inflation. 

So why is inflation of so much interest? For one thing it might have relevance to your own situation. For another it might tell you something about the national economy. It might influence your optimism or pessimism about future inflation, jobs, and income.

Here is where it gets a little complicated and even controversial. When inflation is high, the immediate message is that prices are rising at a faster pace. Most of us frown when that happens. But prices do not rise in isolation. Prices are part of a bigger macroeconomic scene. It depends very much on some of those other things as to how a rise in inflation impacts you and me and the nation.

Suppose we are living through a time of great optimism and growth. Jobs are plentiful and wages are rising. In that environment, a rise in the inflation rate doesn’t seem ominous. Okay the price of eggs went up, but I have a great job and my earnings are growing faster than prices. In that case, inflation is just part of a very positive economic situation.

Instead, suppose we are living through a time in which inflation is rising but people are losing jobs and/or wage growth is stagnant. That is the kind of time when inflation really hurts. Such times are not frequent but do happen and are usually the result of business productivity rising at a slower pace than business costs. Some of us geezers remember the 1970s when the price of energy was rising so fast that business costs were crippling many companies. Stagflation is a term coined to describe this kind of inflation.

Inflation can be part of a successful economy or the result of a very negative scenario. Since the national economy is not simple, different experts can look at the economy and come away with different opinions. Today the inflation rate is very low and some policymakers see this as a very negative sign. They want to use policy to bring the rate up. Others believe the macro economy is not so bad and attempts to engineer a higher inflation rate will come back to haunt us. So stay tuned.