What is Consumer Price Inflation?

A risk to investment and a redistribution of wealth.

When we’re kids, we have no idea what money is and we can’t be blamed for that. Money is an abstraction and we need to be taught how to use it and what it means. There are many different understandings of money to choose from, including:

  • a store of value,
  • a medium of exchange,
  • a source of power,
  • a pseudo-religious statement of faith (e.g., “In God We Trust”),
  • a mass delusion,
  • a mechanism of oppression,
  • a sin,
  • a technology for enabling unbridled avarice, greed, and accumulation.

As adults, we become more familiar with the mechanics — i.e., the details of money transactions. We learn how to work for wages, how to use credit, the necessity of rent, security deposits, and taxes. Nonetheless, one of the things that remains mysterious to most adults is inflation.

When prices are generally going up, we say that the economy is experiencing price inflation, which is the term used by the Federal Reserve Bank (the Fed) for keeping track of what things cost. Every month, the Fed surveys prices at major retailers to see how they’ve changed, and compiles the results in something called the Consumer Price Index (CPI). When prices are higher than the month before, the index goes up. When prices are lower, the index falls.

Figure 1. The Federal Reserve Bank tracks the price of a number of goods called the Consumer Price Index (CPI) to show whether prices are rising or falling, overall. A rising CPI indicates that prices are rising and the purchasing power of the US dollar is declining. Note that a period of high inflation (rising CPI) from 1973 to about 1996 has since leveled off (https://fred.stlouisfed.org/series/CUUR0000SETA01).

Figure 1 (above) shows the value of the CPI from 1947 to September 2018. The most recent reading is about 145, whereas in 1947 it was 33. What that means is that some which cost $33 dollars in 1947 can be expected to cost $147 dollars now. Because the CPI is represents a general increase in the cost of consumer goods (not specific to any one good, but representing the average of things like food, housing, utilities, and transportation) the way we usually interpret an increase in the index is as a loss in purchasing power of the dollar, because it takes more dollars to buy the same goods.

But things are a little more complicated than that, because there are lots of things available to buy today that didn’t even exist in 1947. And improvements in technology has made many things (e.g., televisions) that were very expensive in 1947 much cheaper now.

The Fed attempts to adjust the index for changing consumer preferences and quality improvements from technology. They make regular adjustments to both, which means the correlation between the CPI and actual sales will vary. For example, as computers get faster, the Fed makes an upward “hedonic quality adjustment” in the price they expect people to pay. If the actual market price is less than the Fed’s hedonic adjusted price, the Fed will record that as a price drop — even if the new faster computer costs the same amount as the old, slower one. The Fed argument is that the new computer is a better value, so price per computer speed has really gone down.

Although the CPI is calculated as a dimensionless index, it is usually reported in units of percent per year, like an interest rate. For example, between 1973 and 1981, the US economy experienced high inflation, with prices rising in excess of 10%/yr in the late 1970’s and early 1980’s. These rates of inflation are disruptive to the economy, because market prices change faster than wages and other incomes. Inflation distorts the distribution of purchasing power in the economy by devaluing the dollar.

To understand this, imagine a 1970’s era family that is supported by a single wage earner. Maybe the family has three kids (like mine) and the Dad is the single wage earner (like mine). He works as a University Professor (like mine), and he is accustomed to getting annual raises that adjust his salary based on his job performance and market conditions.

When inflation is low (right now it is about 2%/yr) his fixed salary will be able to purchase 2% less at the end of the year — right before he gets his pay increase. It’s not a big deal.

But what if inflation is 10%/yr or 15%/yr? At the beginning of the year his budget is in balance and he’s paying his mortgage, auto loan, grocery bill, gasoline, and utilities no problem. By the end of the year, gasoline, groceries, and everything else have driven his expenses up by 10%, but his wages remain the same, and he’s falling further behind on his budget every month until he gets his wage increase — which only brings him back to even until prices go up the next month,

The family has a few options:

  • reduce spending,
  • reduce savings or borrow more,
  • increase income (Mom goes to work).
This concentrated corn syrup drink is an inexpensive alternative to soda pop, that was particular to Pittsburgh.

My family did all three. For example, Mom tried to reduced spending on food by mixing powered milk in with our fresh milk. She bought the cheaper cereals. We ate liver and drumsticks instead of breast meat. We drank a disgusting corn syrup concoction called Lemon Blennd. And she saved money on clothes by shopping at Goodwill and Sears. Dad saved money on gas by walking to work, or riding the bus. My sisters and I walked to school.

And Dad borrowed. And Mom went to work.

Inflation punishes savers.

To save money is to postpone spending it. Because a period of high inflation means rising prices, the people who postpone spending will not be able to but as much with their savings when they do decide to spend them — because prices are going up.

The converse is also true: inflation rewards borrowers, because borrowing is the opposite of saving. When you borrow money to spend now, you have to pay it back later. During periods of high inflation, you pay it back with dollars that are worth less. so the sacrifice you make to repay the debt is not as great.

Interest rates typically adjust to reallocate rewards between borrowers and savers, as inflation varies. For example, during periods of high inflation, effective interest rates typically go up to compensate savers for their loss of purchasing power. That is, the real interest rate enjoyed by the saver is not just a function of the effective interest rate, but also a function of the inflation rate.

The math works like this:

To calculate the real interest rate in %/yr, divided (1+effective rate) by (1+inflation rate) and subtract 1 from the result.

The real interest rate is a measure of whether a saver’s purchasing power is increasing or decreasing over time.

For example, suppose a saver is collecting an effective interest rate of 5% on an investment like a bond or a loan they’ve made. When inflation is 2%, the real interest rate the saver enjoys is (1+.05)/(1+.02) — 1 = 2.94 %/yr.

Notice how the answer is very close to 3%. When rates are low, the real rate can be approximated by simply subtracting the inflation rate from the effective, as in 5% — 2% = 3%. But that’s just an approximation. When rates are high, the error increases, and the approximation method becomes unreliable.

As long as inflation remains low, the saver may be very pleased with a real interest rate of nearly 3%, reflecting a general increase in their purchasing power over time of 3%/yr. But what if inflation increase to 10%/yr before the saver can exit the investment?

(1+.05)/(1+.10) -1 = negative 4.5 %/yr

When inflation is high, real rates can become negative, meaning that the saver who postpones consumption is actually losing purchasing power over time. That’s how high and increasing inflation discourages savings (and encourages borrowing).

Although we typically think of inflation as a number greater than zero, it is also possible for inflation to be negative. This phenomenon is called deflation and Europe has been experiencing it as a general decline in price levels over time. It is equally disruptive, because when to calculate real interest rates in a deflationary environment, you discover that the borrowing money becomes extremely expensive. To correct for deflation, interest rates on savings in Europe have also turned negative in some countries like Germany. That means that a deposit of 100 euro in a German bank might have only 99 euro at the end of the year — an effective interest rate of negative 1%/yr. In other words, German depositers have been paying their banks for the privilege of keeping their savings at the bank, when in fact they’d be better off stuffing their mattresses with paper currency. Negative interests rates are extremely dangerous in this way, as they create incentives for savers to opt out of the banking system altogether.

There are some important political, geographical, and intergenerational implications to inflation. Because high inflation rewards borrowers and low inflation rewards savers, we can make some general inferences about how inflation impacts different generations and locations.

Banks lend money. When inflation is low, bankers benefit and borrowers pay. In the United States, the banking centers are in New York City (stocks, investment banking firms), Boston (e.g., for mutual funds), Hartford CT (e.g., insurance), and San Fransisco (e.g., venture capital). Borrowers tend to be in the middle of the country, where people need loans to farm, ranch, drill for oil, or manufacture goods. Thus, when inflation is low, the Northeastern US and San Fransisco do very well, at the expense of the rural States in the middle of the country. When inflation is high, the opposite is true.

When we’re young, our borrowing needs are high. We need loans for college, for purchasing vehicles and home, and for raising our own kids. As we age, we pay off our debts and become savers. In other words, we go from borrowing to lending. Thus, young people benefit from rising inflation that makes it easier to pay back loans.

When I was a young child in 1973, Vice President Spiro Agnew resigned his office under a cloud of corruption allegations. Gerald Ford was appointed the new VP andhe became the first President of the United States who had never been elected on a presidential ballot when Nixon later resigned his office.

The WIN campaign sought to encourage consumers to save money in the early 1970's. Public Domain, https://commons.wikimedia.org/w/index.php?curid=20770484

Before his resignation, I had written a letter to President Nixon (Mom typed it up for me) encouraging him to promulgate policies for more urban light rail (I called them “trolleys” as they were known in Pittsburgh and on the popular PBS children’s show, Mr Rogers Neighborhood).

I didn’t get a response to my letter until 1974, when someone from now President Ford’s office wrote me a nice thank you letter for expressing my concern. They included as a gift to me, a “Whip Inflation Now (WIN)” button encouraging me to save money. Which, as a child of 8, I considered it my patriotic duty to do.

I was an idiot.

The WIN campaign was one of several misguided — even macabre — political and economic policies of the 1970’s that only began to end when President Jimmy Carter (having defeated Ford in 1976) appointed Paul Volker to be the Chairman of the Federal Reserve Bank. Volker jacked up near term interest rates to 22%/yr, choking off the supply of debt and new money, plunging the economy deep into recession and ending inflation.

The boom in stock prices, coastal real estate, and some might argue innovation and technology, that we have enjoyed since about 1981 all began as a consequence of Volker’s actions in the late 1970’s. While the boom was interrupted by recessions the early 1990s’s, the dot com bubble burst in 2001, and the Great Recession that was the collapse of the real estate bubble in 2007–2008, each time the Federal Reserve responded by dropping interest rates and flooding banks with new dollars. The big surprise is that this profligate creation of new money has not manifested itself in the form of higher consumer prices.

All prices are ratios — e.g., the ratio of dollars per gallon, or dollars per hour. as such a price is a function of relative supply and demand. To understand price pressures, you have to have an understanding of both the supply and demand for dollars (the numerator) and the supply and demand for the goods in question (the denominator). When there is an interruption in production of a good, prices go up because the supply in the denominator goes down. And when the supply of dollars goes up, prices go up with it, because the supply of dollars in the numerator of a price ratio is increasing.

The Federal Reserve Bank controls the supply of dollars by lending more money (lower rates) or lending less (higher rates). Thus, the federal Reserve Bank makes adjustments in the interest rates they set to target measures of inflation like the CPI at around 2%.

When inflation runs lower than 2%, the Fed favors older generations living in the banking centers in dense urban areas — especially New York City and San Fransisco. When inflation is higher, the banking centers get hurt and purchasing power flows to the middle of the country (e.g., farmers) and to younger generations.

Thus, the FED not only controls the money supply, but because there are certain people (young/old) and regions of the country that relate to money in different ways, the fed also controls the distribution of money between those regions.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.