Inflation: The Good, the Bad and the Ugly

In the world of economics, inflation is one tricky term. Everyone knows that prices go up over time. 60 years back you could buy a loaf of bread for $0.15, which now costs around $2 - $3. However not everyone understands the forces behind inflation. So let us find out.

What is Inflation
Inflation refers to a general rise in prices for goods and services measured against a standard level of purchasing power. As inflation rises, every dollar you own buys a smaller percentage of a good or service. For example, if the inflation rate is 5% annually, a good or service costing $100 will cost $105 in a year. (Note: The goal for most developed countries has been to sustain an inflation rate of 2-3%)
There are few variations of inflation you need to know.

Deflation: When there is a general fall in prices for goods and services. This is opposite of inflation.

Hyperinflation: When there is sharp rise of inflation. This could lead to a breakdown of the monetary system.

Stagflation: When economy becomes stagnant. This could lead to high unemployment rate.

What causes Inflation ?
There is no one cause that's universally agreed upon, but at least two theories are generally accepted.

Demand Pull Inflation: If demand for goods/services is growing faster than supply, the prices will increase. This usually occurs in emerging markets/growing economies.

Cost-Push Inflation: If there is a sudden decrease in supply, the prices go up. This in turn increases the cost of doing business for most companies. To maintain their profit levels they in turn increase the price of their goods/services which would ultimately be passed on to the consumers in the form of increased prices.

How is inflation measured ?
Inflation is measured with a price index which can be thought of as a large survey. One way of measuring inflation is by comparing two sets of goods at two different times, and calculating the increase in cost. There are many measures of inflation depending on the specific circumstances. I have listed few of the widely used ones.

Consumer Price Index (CPI): Measures consumer prices from the perspective of the buyer. (For eg. prices of gas, car, food)

Producer Price Index (PPI): Measures prices received by a producer/seller. PPI will give a clear indication of the pressure being put on producers/sellers. Normally this is passed on to the consumers, or producers/sellers reduce profits or they increase productivity. A subset of PPI is the Wholesale Price Index (WPI) which measures prices of goods at wholesale prior to retail prices.

GDP Deflators: Measures an entire economy as the basket of goods and services, rather than some particular subset.
Other note worthy measures are commodity price index & purchasing power parity.

So who actually measures Inflation ?
Each month, the U.S. Bureau of Labor Statistics contacts thousands of retail stores, service establishments, rental units and doctors to obtain price information on thousands of items used to track and measure price changes in the CPI.

How about interest rates ?
In US, interest rates are decided by the Federal Reserve. They meets 8 times/year to set short-term interest rate. CPI and PPI plays a big role in the decision making process. Generally when the interest rate drops, consumer spending increases which in turn is good for the economy.

How does Inflation affect investments ?
Inflation can affect/not affect certain type of investments. Let us find out which ones.

Affects people living on a fixed income, such as students & retirees. (Reason: Purchasing power drops)

Does not affect people investing in stocks, provided the company's profits increase at the same pace as inflation. (Caution: In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth)To protect yourself from inflation, you can buy inflation indexed securities. However these securities are so safe, they offer an extremely low rate of return which disinterests most investors.

So Is Inflation Evil ?
Yes and No. People like to complain about prices going up, but they often ignore the fact that wages are also rising. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages.

It is evil or not depends on whether inflation is predictable or unpredictable.

If inflation is predictable, the affect can be compensated. (For example, banks can increase their interest rates, workers can negotiate wage hikes to combat inflation.)

If inflation is unpredictable, there will be imbalance. (For example, lenders tend to lose if they do not anticipate inflation correctly, companies spend less when there is uncertainty and indirectly hurt the economy, fixed income investors see a decline in their purchasing power, domestic products become less competitive hurting exports.)So to sum up if inflation is evil or not actually depends on the overall economy as well as your personal situation.

Conclusion: Inflation is a sign that an economy is growing. Little inflation can be just as bad as high inflation. High inflation can break the monetary system where as lack of inflation may be an indication that the economy is weakening. I believe moderate rise of inflation is good for the economy and that is what every country tries to achieve.