Over the past few months, news algorithms continue feeding me alarming articles about inflation. So, I figured I should take a minute and explain what inflation is. But, before I dive in, I feel it’s probably helpful to tip my cards. I believe our current inflation is a short-term phenomenon driven by COVID related complications and is not a long-term concern, but the fear of inflation can sometimes become a self-fulfilling prophesy — so I’m keeping a close eye on it and I’ll keep you posted.
What Is Inflation?
Inflation is the rate at which a currency loses its purchasing power as prices increase over time.
So, say a cup of coffee cost $1.00 twenty years ago. With very modest inflation – say around 2% – that cup of coffee costs $1.50 today.
Various goods, services, and sectors often experience different rates of inflation at different times, but general inflation is usually calculated based on the Consumer Price Index (CPI).
Recent headlines have been reporting a noticeable uptick in inflation. Superlatives like “best” and “worst” grab the most attention, so outlets have been abuzz with reports of how a 5% May consumer pricing surge was “the biggest 12-month inflation spike since 2008.”
As an aside, most financial news is clickbait and should be taken with a grain of salt.
Putting Inflation in Proper Context
But, here’s the problem with all of those scary headlines. They’re using year over year data. For example: They’re comparing May 2021 to May 2020, when we were still deep into the pandemic when everything was thrown off. The WSJ explained, “If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track.”
Zooming out even further, the Federal Reserve’s 10 Year Break-Even Inflation Rate is one common estimate of the market’s expected average annual inflation rate for the next 10 years. As of mid-June, that rate stood at 2.3%. That’s up from the lower 1.2% rate expectation from mid-June 2020, but it’s still not eye-popping.
But, one more important point: Not all inflation is bad.
In fact, a bit of inflation is a good thing. Good inflation goes hand in hand with economic growth and reasonable interest rates for lenders and borrowers alike. A 2% annual inflation rate is typically considered desirable.
What if Inflation Runs Amok?
But, it’s concerning if inflation gets out of control. Here’s what happens with out-of-control inflation – we’ll have a lot of uncertainty, wreaking havoc on commerce, the economy, job markets, real estate, and financial markets.
Side note: Deflation—the opposite of inflation—can also upset the economy and can be just as damaging as inflation.
If you were paying attention in the 1970s you may remember the last time the U.S. experienced red-hot inflation, and what it felt like when it spiked to a feverish 14.8% in 1980 (The year of my birth – so not all bad).
The New York Times described it as an era when “prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 percent, and interest rates on bank certificates of deposit approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.” While 12% CD rates may sound great, when interest and inflation rates are comparable, the real returns from even high-interest CDs essentially become a wash.
After the 1980 high-water mark, the Volcker-era Federal Reserve tamped inflation back down. So younger investors have heard of, but never experienced such steep inflation for such an extended time. Despite occasional alarm bells, inflation has mostly continued to hit the snooze button for decades. At least so far.
Right now, I’m not overly worried about out of control inflation, but it’s definitely something we’re keeping our eyes on.