Understanding Inflation

Inflation is the condition when the money available for goods and services grows faster than the supply. Causes include changes in the money supply, changes in consumer spending, and changes in government spending. Whatever the cause, the result is an increase in prices. Indeed, most inflation measures are estimates of rates of change in price, whether they pertain to changes in the prices of consumer goods like milk and eggs, or changes in prices of producer goods such as steel and lumber.

Measures of inflation abound. Some measures fluctuate more than others, and some measures affect business producers more than consumers, and vice versa.

The US Bureau of Labor Statistics (BLS) publishes variations of the Consumer Price Index (CPI) and the Producer Price Index (PPI) each month. We refer to year-over-year changes in CPI as consumer price inflation, and year-over-year changes in the PPI as producer price inflation. The table below shows consumer price inflation was 3.2% from October 2022 to October 2023.

For example, using the price of eggs:

Step 1. Obtain two observations in the same price index, one year apart.

In October 2022, the BLS price index for eggs was 328.423.

In October 2023, the price index for eggs was 255.489.

Step 2. Divide the latter price index by the earlier price index and subtract one. That is the year-over-year change in the price index.

255.489 / 328.423 – 1 = -22.2%.

During 2022 there was much concern about how much the price of eggs had increased. In 2021 egg prices rose about 11%, and in 2022 they rose another 60%. The calculation above shows they have fallen some 22% since October 2022.

While this calculation shows that prices of eggs fell year-over-year by 22.2%, Table 2 shows the prices of consumer foods have changed during that period by only by -2.3%, illustrating that different items’ prices do not all rise and fall at the same rate.

To calculate the price index of a basket of goods, BLS simply sums the price indexes of the individual components according to their weights.

While that simple explanation might not seem controversial, issues arise when deciding whether the weights change over time, and how, because of how many contracts (especially government payments) are linked to measures of consumer price inflation.

In the early 2000s, the BLS introduced chain-weighted CPI. Chain weighting was based on the idea that consumers do not keep their shopping constant, especially when prices change. Chain weighting involves averaging a set of weights one month and a separate set of weights the next month, reflecting how consumers change their consumption.

While this calculation method might seem reasonable, consider that it tends to result in lower measures of inflation, which affect cost of living adjustments (COLAs) for all kinds of contracts and measures. Based on chained inflation, the COLA for Social Security retirement benefits would not be as high. Nor would increases to federal income tax brackets, which means you might be paying more in taxes than you would if the bracket increases were based on unchained measures of inflation.

Imagine the price of cheese goes up a lot. The price of your favorite pizza will also go up because the pizzeria will pass along the cheese price inflation to you in the form of pizza price inflation.

Inflation means a dollar will buy you less of something in the future than it does now. If it is easier to think of it this way, instead of considering how much prices rise on a specific item, consider how much less of that item the same amount of money can purchase.

For example, let us say the price of milk has doubled at your grocery store from $3 per gallon to $6. One way to think of it is that the price has risen 100%.

Consider a student who knows his weekly budget for driving to school. If the price of gasoline rises too much, the student might switch to public transportation, which is less convenient, and less safe. Otherwise, he might have to take a part-time job to pay for the unforeseen expense. The job might limit his opportunities to mingle with fellow students and meet on-campus recruiters.

Changing prices change lives.

Inflation expectations form a key part of the Federal Reserve’s thinking behind its setting of interest rates and open market activities. In general, the interest you can earn in interest-bearing cash equivalents, such as money market mutual funds, rises and falls with inflation expectations. However, the level of interest rates might not necessarily always compensate you for expected inflation, especially when the Federal Reserve is concerned about the economy slowing into a recession.

The Federal Reserve’s dual mandate is to maintain full employment and to maintain stable prices. These mandates are at odds! Maintaining full employment can be inflationary and fighting inflation can lead to job loss and recession. When inflation emerged in late 2021 and 2022, the Federal Reserve began raising interest rates aggressively, with the objective of dampening economic speculation. The Federal Reserve mostly aims for 2% to 2.5% inflation; when inflation is above the target the Fed raises rates and when it is low the Fed tends to lower rates. As difficult as the dual mandate might be, it is even more challenging amid pandemics, global supply chain problems, and foreign wars, none of which is controllable by changing interest rates.

If a dietary staple such as eggs costs too much, consider nutritionally equivalent substitutions. You might be pleasantly surprised by how much you enjoy the substitute. During periods in the 19th Century when it was difficult to obtain coffee, Louisianans stretched their coffee with roasted endive, also known as chicory. Chicory coffee has remained as a beloved coffee style ever since.

When inflation subsides to tolerable rates such as below 3%, do not expect prices to fall. When inflation declines to such tolerable levels, some prices may remain at their higher plateau, so you might still need to adjust your spending habits accordingly.

Using GuidedChoice’s and 3Nickels’ planning tools can help you plan by taking inflation into account. We present our retirement projections and base our retirement recommendations on how much you will be able to spend in retirement in current dollars, which means we take inflation into account.