Oh Nooo Not More Infaltion Garble...

When you are talking to your friends or are at the dinner table with family can you think of a type of conversation that, regardless of your personal experiences, gets everyone fired up? I’m willing to bet that this is the same kind of conversation that some of you flinch at when you hear the two magical prefacing words; “hypothetically speaking”. Part of the fun and frustration is that there is either no right answer or lots and lots of variables to consider. I have a conversation like that for us today. When the dinner time conversation turns to finance and the economy, inevitably someone is going to bring up inflation. Today I hope to give you some intellectual ammo in the event of an arm chair economist face off. Hypothetically speaking of course.

Today we are going to cover what inflation is, how it’s calculated and its different causes.  At the end of today though be sure to check out the link to the Massachusetts specific inflation page from the U.S. Bureau of Labor Statistics. Time to let the variables fly! 

Inflation is defined as the increase in the price level for goods and services over time.  The biggest tool that the Bureau of Labor Statistics uses to determine the changes in prices levels is the Consumer Price Index or CPI. Think of the CPI as a picnic basket full of goods and services that you, as a consumer, use every day. CPI takes price and weighted use of goods and services data from over 87 urban areas and 27,000 retail and service establishments to track changes in the economy’s price level. Within the CPI are categories that range from housing, rent, and new vehicle purchases all the way to the eggs, milk and bread you use every day. CPI measures price fluctuations as percentage changes from month to month and from fixed points like December 2008 and 1967. What setting points of reference allow economists to do is to find patterns and make conjecture about where inflation has been and where it might go in the future.  That conjecture is what the Federal Reserve and the current Administration use to make decisions on fiscal and monetary policy. The CPI gets the data it uses to calculate price changes from the Consumer Expenditure Survey put out by the Bureau of Labor Statistics. 

Let’s set up a small example that illustrates inflation at work. If on the news you hear that inflation has gone up 3% in the last year what does that mean for the consumer? Well for starters that $1.00 soda in the grocery store effectively costs $1.03. Inflation reduces the real purchasing power of your dollar, or it takes more dollars to purchase that same good. Inflation is not just about prices going up and I don’t want you to stop reading here and think that it’s all bad either. In fact in a healthy growing economy you need a certain level of inflation so that prices don’t get out of control and that workers all over the country get wages they deserve. Inflation as an economic indicator is used to mediate wages, adjust fixed income streams like Social Security, and affects the cost of your children’s school lunch programs.

There are basically two major economic causes for inflation, a Demand-Pull and a Cost-Push. Keep in mind we are covering the topics in brevity and making assumptions along the way like not considering demand elasticity, substitution, and market competition. When there is a Demand-Pull it implies there is too much money floating around in the economy chasing too few goods. People are willing to spend more for the same goods. When the news talks about worries of the Treasury just printing money or the debate over the effectiveness of stimulus checks being sent out to everyone they are referring to a Demand-Pull concern. The biggest part of that concern is that prices will rise too quickly, which is called hyperinflation, and imagery of an early 20^th Century Germany comes to mind with rapid devaluation of a currency and unimaginable bread lines. On the other side is Cost-Push which has more to do with the costs that companies have to incur in the production of goods and services and the ultimate effect on the price the consumer pays. Here the variables are more in line with resource scarcity like with timber and other natural resources that have inherently fixed amounts of inventory. The taxes on the raw materials imposed by the government and the cost of imports are also factors. Ultimately if the costs of production increase, with no foreseeable substitutes available, then the costs to the consumer will increase which implies inflation.

I hope you are starting to see why there are so many debates over what the causes of inflation at any given time actually are. With that debate goes the debate over what kind of policy should be enacted to address it at any given time as well. It’s a calculation that is much easier to see in hindsight when consumers have made their purchases and suppliers have shipped their goods. As promised take a look at how Massachusetts is doing compared to the rest of the country.  If you are still confused give one of my favorite economists and books read, its Naked Economics: Undressing the Dismal Science.  I think if you give Charles Wheelan a chance he makes this stuff fun and is extremely well spoken. 

Cheers!