Q: What is Inflation? What are the causes?
A: Inflation is the word used to describe the phenomenon of rising costs or prices. It’s a key part of any healthy economy, but at the right level.
Price stagnation or falling prices, known as deflation, tends to be unhealthy because it leads people to stop spending and investing habits that fuel growth. But high inflation, especially inflation above the rate of wage growth, also distorts the economy and can lead to recession when people slow down their spending.
The central bank of the United States, the Federal Reserve, considers a healthy level of inflation to be 2% per year. Its policymakers aim for this level when considering interest rates, their main tool to stimulate or cool the economy.
Until recent months, only twice since 1990 have Americans seen inflation, as measured by the consumer price index (CPI), exceed 5%. For much of the past decade, it was below 2%. In December, the latest month for which data is available, the CPI rose 7% from its level a year ago.
Q: Why is inflation so high today?
A: The pandemic has brought the world economy to a screeching halt and a recession in many countries, including the United States. Demand for many goods fell sharply at the start of 2020 and remained relatively weak until vaccines arrived and got people back to work reducing the threat of COVID-19.
As businesses and economies reopened, pent-up demand for goods soared, especially since consumers weren’t spending as much on services like travel. Factories, farmers and other goods producers could not keep up – and prices rose sharply. In countries like the United States that provided financial assistance to citizens in 2020, the extra money available and the desire to spend it helped drive up demand. Inflation historically jumps at the start of an economic rebound, but the change this time shows the difficulty of restarting all the things that were turned off when the pandemic hit.
Meanwhile, the United States has seen a decline in the number of people available to work as more baby boomers, who have dominated the workforce for the past 40 years, head into retirement. This led to more production constraints or limits on how quickly supply could catch up with demand, which could ultimately slow price increases.
Q: Should prices come back down?
A: No. Once prices rise, especially for services, they rarely come back down. However, some commodities, such as oil and natural gas, tend to fluctuate wildly. When they pull back, lower prices for consumers often follow.
Q: How much would wages have to be raised to see them counter inflation?
A: If wages don’t keep pace with consumer prices, people fall behind in their ability to afford things. Their standard of living is falling.
Q: How is Minnesota affected by the current level of inflation?
A: Minnesota and the Midwest were hit by bigger jumps in inflation than the country as a whole. This is largely because the region has large rural areas where driving distances are often longer and where sharp increases in gas prices have an outsized effect.
Q: When was the last time inflation was this high?
A: The last time inflation in the United States was this high was in 1982. But that was at the end of a period that began in 1965 when inflation rose from 1% and finally reached 14% in 1980. In contrast, this current surge comes after 2020, when inflation was well below 1%, and in previous years, when it was consistently below 2%.
Q: Is inflation always bad?
A: No. Inflation is widely considered better than its alternative, deflation. Both are harmful because they cause instability in the purchasing power of money, which leads people to spend or invest less and ultimately lose faith in monetary and credit systems.
A small amount of inflation is more manageable than deflation because people can adjust slowly. And rising prices tend to strengthen production, innovation and employment. But if there is high inflation and people begin to believe it won’t stop, they will cut spending, reducing demand for goods and services and eventually leading to recession.
Q: What is the consumer price index and how is it calculated?
A: There are many measures of the evolution of costs and prices, but the consumer price index collected by the Bureau of Labor Statistics is the main benchmark for inflation. The CPI is composed of average price data for approximately 80,000 goods and services collected through monthly surveys of 6,000 households and 23,000 retailers. There are subsets of the index by region and by state. The survey does not include people living on farms or in towns with fewer than 10,000 people.
Q: What does it mean when the Federal Reserve raises interest rates in response to inflation?
A: The 1977 Congress mandated the central bank to promote maximum employment and stable prices. Around this time, a consensus formed that the country cannot achieve full employment if inflation gets out of control. Low interest rates tend to encourage businesses to borrow money, spend, invest and hire. Such increased economic activity, however, can drive up prices and ultimately destroy jobs.
To control inflation, the central bank raises interest rates. Since the 2008 recession, the central bank has kept interest rates well below historical levels. And at the start of the pandemic, rates were reduced to practically zero. The Fed is planning two or three rate hikes this year, with the first scheduled for March.