A Brief Primer on Inflation: What Is It and How Does It Work?
Econ is a tricky thing to understand, many people think they have a solid grasp on it, but few actually have a holistic comprehension of the metrics and terms used to measure it. Even among economists, who literally measure these things for a living, there are tons of disagreements back and forth on what the proper way to grasp what is going on with the economy at any given point is.
Given that my previous piece on the U.S. economy and public perception gained more traction than I initially thought it would and that misunderstandings surrounding inflation was a decently large section of it — I thought it would be appropriate to create a companion piece of sorts, going over the basics of inflation in hopes of contributing to public literacy on the subject.
To begin let’s ask the question, “what even is inflation in the first place”? Well, Inflation is calculated as a derivative of the purchasing power of the dollar. In other words, it measures the general rate of change for prices in the economy (specifically the rate of change in the increase of prices). To simplify this let’s limit our focus to the price of a single commodity — in this case milk. If a carton of milk was priced at $4.32 in January and that price raised to $4.56 by February, you could say that the month over month inflation rate of milk was roughly 5.6%.
Of course, in reality inflation doesn’t refer to the price of any one commodity but the averaging out of increasing prices across the entire economy. Now you may be asking “Where do we derive those broad collections of prices from in the first place?” There are a few indexes economists look to in order to develop these measurements of inflation, but for our purposes we will focus on the 2 most popularly utilized ones — the Consumer Price Index (CPI) and the Producer Price Index (PPI).
The CPI is a weighted average of a basket of goods and services meant to be representative of aggregate U.S. consumer spending and is calculated by the Bureau of Labor Statistics (BLS). It is the most widely used measure of inflation, closely being followed by policymakers, economists, and businesses alike. The CPI’s market basket is developed using data collected in detailed expenditure surveys of families and individuals. This process is used to decide the importance, weight, and item categories of what ends up being part of the index.
The index can be arranged into 8 major categories, those being “food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services”. Prices are collected by the BLS monthly from about 23,000 retail and service establishments as well as surveying approximately 50,000 housing units for the shelter category’s prices — which accounts for about 1/3rd of the overall CPI.
The PPI — on the other hand — is a measure of the change over time in the prices domestic producers receive for their goods and services. It’s meant to measure inflation from a wholesale perspective, compiling thousands of indexes to ascertain producer prices by industry and product category. To do this it uses a sample containing over 16,000 establishments which provide approximately 64,000 pricing quotes per month.
The BLS publishes the PPI monthly, and while consumer and producer price trends are unlikely to diverge over long periods of time, measurement of the PPI can pick up on divergences in inflation from the CPI in the short-term — generally as the result of things like subsidies, taxes, and distribution costs.
There are 3 main PPI classification structures which all draw from the same informational pool, those being industry classification, commodity classification, and commodity-based Final Demand-Intermediate Demand (FD-ID). Industry classification is the process by which the PPI includes indexes for producer prices derived from approximately 500 industry categories based upon output sold outside the industry — in other words its net output.
Commodity classification organizes products and services by similarity and material composition, disregarding the producer’s industry to group output. This is a system that is unique to the PPI, it publishes more than 3,700 commodity price indexes and around 900 for services — all organized by product, service, and end-use.
Finally, FD-ID regroups commodity price indexes for services, goods, and construction by the type of buyer and the amount of physical processing the products have gone through. The PPI publishes more than 600 indexes measuring changes in prices for goods, services, and construction sold to final and intermediate demand. It’s the final demand indexes that are then used to arrive at the headline PPI number.
It’s important to reiterate the fact that inflation specifically refers to increasing prices, so whenever you hear sentences like inflation is “__” remember this is relative to a rate of increase. When prices are falling what we have is deflation, not to be confused with disinflation which refers to a reduction in the rate of inflation.
This is a point people often forget or mix up, and it can lead to them feeling as though they have been misled by technical expert statements such as “inflation has fallen by 25%”. Without a firm grasp on exactly what the terms mean, it can be easy to think this means prices have dropped 25% (which would be a quite significant decrease in prices overall).
Even with a passing familiarity with the terms, statements like these can make people think the rate of price increase has fallen by 25 percentage points instead of being a 25% reduction from the previous inflation rate, for instance falling from a rate of 10% to 7.5%.
There’s one final aspect of things I’d like to go over in this basic overview of inflation as a concept. Let’s talk a bit about the 3 different types of classification inflation can broadly fall under: demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation occurs when an increase to the money supply leads to a subsequent increase in demand for goods and services at a rate supply is incapable of keeping up with. This in turn leads to an increase in prices until the demand at the new prices balances out with the economies production capacity for what is being demanded.
For example, imagine everyone across the economy suddenly received a hefty bonus to their paycheck. This may lead to an uptick in people looking to go on vacation, in turn increasing demand for flights, but as there is a limited supply of planes and seating you might see ticket prices begin to rise significantly as demand at lower prices out paces the ability for airlines to keep up.
Cost-push inflation happens when increases in prices along the chain of production occur. As a result, businesses end up increasing their prices in order to make up for rising costs. This can often kick in concurrently with demand-pull inflation when consumer spending leads to more demand across the entire production line causing an increase in the cost of the raw resources used to create the products consumers are spending their money on.
For this, you can think of things like changes in the geo-political status of different primary exporter countries leading to increases in the prices of oil or other resources, leading to other products in the economy that rely on those resources to be made to also increase in price.
Built-in inflation refers to adaptive expectations surrounding people thinking inflation will continue to exist at elevated rates, and as a result demand higher wages to maintain their standard of living. In turn the rising wages raise costs for businesses resulting in them increasing the prices of goods and services leading to what is called a wage-price spiral. This is generally regulated by our central banks through the use of monetary policy, interest-rates, open market operations, and reserve requirements.
So, to sum things up, inflation is a representation of the rate of price increase across the economy, its measured using price indexes such as the CPI and PPI, and there are 3 main categories it is often organized into — those being demand-pull inflation, cost-push inflation, and built-in inflation.
Obviously, there is far more complexity that we could go into on the subject, but I believe what we’ve discussed here presents a decent foundation for understanding the concept in a meaningful manner which ideally can serve as a springboard for further exploration in the future. At the very least, I hope it leaves you with the feeling that the next time you hear a statement being made about inflation you’ll be more equipped to decode exactly what is being said.
