Inflation is too much money chasing too few goods. It is a measure of the rate of rising prices in goods and services in an economy.
Although inflation can occur in any product or service, it generally refers to the increase in prices across the economy as a whole. In the United States, the most commonly used metric of inflation is the Consumer Price Index (CPI). The CPI measures the price of a basket of goods, including education, cars, food, recreation, and many others. As its name suggests, it represents changes in prices purchased for consumption in urban households.
Because of inflation, prices a year from now will be higher than prices today, broadly speaking. It’s why a McDonald’s cheeseburger costs $2.99 today and used to cost 10 cents. This erosion in purchasing power is essentially a “tax” of sort on savings. $100 in the bank today will not be worth $100 in 2022 – it will be closer to $98. This fact forces savers to make a decision: pay the tax or seek out returns to at least match the cost of inflation.
What Causes Inflation?
There are 3 primary causes/drivers of inflation: costs increasing, demand increasing, and fiscal and monetary policy. Remember: inflation is just the measure of the rate of rising prices.
- Costs Increasing – When production costs increase and demand for the product/service stays constant, the business is likely to pass on their higher costs to the consumer by raising prices. An increase in wages – which are typically the highest cost for an employer – is a perfect example and is highly correlated to a raise in prices on a finished good.
- Demand Increasing – When supply remains constant and demand increases, higher prices are likely to follow. Generally speaking, in times of economic expansion, consumer spending increases, leading to higher prices.
- Fiscal and Monetary Policy – Fiscal Policy refers to government spending and taxes whereas Monetary Policy is the actions taken by central banks to achieve macroeconomic goals. Policies taken to increase the supply of money will have inflationary effects. For example, lowering interest rates and distributing stimulus checks both increase the supply of money.
Why does the Federal Reserve Want Inflation?
Why does the Fed target 2% inflation? Why not zero? Or a negative number (deflation)?
There’s a lot of discussion around this topic and a general agreement has yet to be reached by economists. However, there are 3 main arguments made in support of the 2% target.
- Measurement Bias – Inflation itself is extremely hard to measure, leading many to believe it is often overstated. This means, when the CPI shows 2% inflation, we may actually be closer to 0%.
- Room to Cut Interest Rates – It’s believed that interest rates and inflation run in tandem to each other. Therefore, inflation needs to be positive and at least high enough to give the Fed room to lower interest rates in the event of a recession.
- Avoiding Deflation – Deflation is the downward movement of prices. Some believe that deflation is worse than inflation, as consumers will put off spending as they wait for prices to fall. This lack of spending would undermine the economy, putting downward pressure on everything and likely lead to lower GDP growth.
Towards the end of 2020 and in the beginning stages of 2021, the Federal Reserve has made a major adjustment to its inflation policy: instead of targeting a 2% fixed goal, they are now pursuing a 2% average. Given the low levels of inflation over the past several years, expectations are to see the Fed targeting greater than 2% inflation over the next few years, thus hitting their new goal of a 2% average.
What To Do About It in 2021
Whether the Fed’s policy on inflation are right or wrong is up for debate, but the likelihood of higher inflation in 2021 and beyond has been increasing. The increase in Treasury yields signals more and more investors are betting on higher inflation (Treasuries no longer look attractive as higher returns will be necessary to combat inflation). Where should investors turn?
Assets, typically in all forms, fare much better than cash. Tangible assets, like real estate and commodities, have long been regarded as safe havens during periods of inflation. Wanting to buy more stocks? Try to locate companies with increasing profit margins. This means their pricing power has increased more than their production costs, meaning more earnings for shareholders.
Talk to Price Wealth Management today about how you can best prepare for 2021 and beyond.