The Truth About Inflation

In short, here is what you want to know:

• Low to moderate inflation is good. High inflation is bad. Deflation is the absolute worst.

• Inflation rate refers to the percentage change in prices vs the previous month or year.

• While the rate of inflation is currently falling, that does not mean that prices are coming down. Rather, prices are still going up, all be it at a progressively lower rate than they have been for over a year.

Prices are not going back to pre-Pandemic levels.

There is a common misunderstanding that prices must go back to 2020 levels for the war on inflation to be won. This is not the case. In fact, if that were to happen, it would be devastating to most people and especially to those that are the most economically vulnerable.

Although the rate of inflation is getting close to its target of 2% annually, it is still too high. But, we’re getting close. Therefore, it’s a good time to talk about inflation so that you’re not needlessly fixated on an old narrative when it will no longer be an issue.

This is what you need to know about inflation right now...

• Inflation is high.

• We are in a period known as “disinflation” which means that the inflation rate is falling. This has been the case for over a year.

• However, the rate of inflation is still too high and it needs to come down more.

• But not too much more, because you do not want to be in a deflationary environment, as that is far worse and much more difficult to manage than high inflation.

• Also, prices are still much higher than they were pre-Pandemic.

• But, whether you realize it or not, you do not want prices to get back to their pre-Pandemic levels.

Good lord. No wonder so many people are confused and easily manipulated by this topic. If you’re one of them, don’t fret. Even the POTUS is confused about how inflation works.

But alas, that’s not how any of this works.

So, how does it work?

To answer that, let’s start by defining inflation.

According to Investopedia, inflation is “a rise in prices which can be translated as the decline of purchasing power over time.”

Well, that sounds terrible. How can anything good come of that??

Like most things in life, there is much more than meets the eye here. I’m sure some of you have seen this horrendous looking chart tracking the buying power of a dollar from 1913 to 2020:

Yikes! That certainly looks terrifying.

However, there is a function to inflation which the talking heads on TV and purveyors of economic doomsday porn do not speak about because it requires a little bit of thought. And thought does not equal easy engagement via uninformed outrage.

But you’re here reading this, which means you’re smart. So let’s discuss the good and the bad of inflation.

The bad part of inflation.

The biggie here is that it erodes purchasing power over time. Meaning things will cost more in the future than they do today, just like the cost of things today are more than they were in years past. This in turn causes the value of money sitting in savings and checking accounts, under mattresses, in the walls, in piggy banks, and buried in the woods to be less valuable every year.

The erosion of purchasing power impacts low wage earners and retirees the most, which in turn propels wealth inequality. It also lowers real wages, which are wages adjusted for inflation, if annual raises are less than the inflation rate. Ironically, if wages were to keep up during periods of high inflation, the outcome would propel inflation rates even higher.

High inflation rates also lead to increased costs to borrow money, which discourages investments and reduces international competitiveness. This in turn leads to lower growth and instability in the economy which can lead to a shortage of available goods.

Prolonged periods of this mess results in the perfect recipe for social unrest.

So, yeah. It’s pretty important to make sure that inflation rates are kept in check by good financial and economic policy by The Fed, Treasury, and Congress.

How could there be anything good about inflation?

For starters, moderate inflation improves the functioning of the labor market. It does so by enabling the adjustment of wages without employees having to take wage cuts. As the cost of living goes up, employers can simply not offer raises to lower performing employees. While this leaves their nominal wages (non-inflation adjusted wages) the same, doing so also lowers their real wages (inflation adjusted wages). Leaving more money available for higher performing workers and investments.

Accordingly, those employees that are the most productive and continue to learn, improve, and apply that additional knowledge appropriately benefit by having more bargaining power.

In addition, moderate inflation increases employment opportunities for all, while also deterring excessive unemployment during minimal economic slowdowns. All of which helps keep unemployment low the vast majority of the time and makes for a better functioning labor market with high participation.

Inflation also makes debt cheaper to payoff which leads to more spending and investments. This enhances economic development and boosts economic growth, which in turn brings more people out of poverty as well as adding to the prosperity of more people.

But, wait. There’s more.

The increase in economic activity provides a perfect environment for innovation and inventions. Resulting in more economic activity, more growth, more… well, you should get the point by now.

Inflation is just a necessary part of an economic system which benefits the most people.

Without low-to-moderate inflation, there would be far less economic growth over time. Leading to less opportunity for upward mobility which would negatively affect the most vulnerable far more than without. This also decreases your odds of achieving financial freedom.

So, no need to fear inflation or get all bent out of shape that it exists.

Now that you understand what it is and it’s function, be sure to check out the next post about how inflation is tracked.

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