Understanding Inflation: Everything in Moderation

Previously I wrote about growth and how the current downturn fits into historic context. This month we’ll discuss inflation, the other key anchor of economic policy.

Inflation is defined as a process of rising prices for goods and services. The inflation rate measures this change using a basket of essentials like housing, transport, energy, and food.

Equally important here is the underlying value of a good or service. If inflation increases, the value – or purchasing power – of your money will decline. Penny candy costs more than a penny today, and the price of basic groceries is higher than 20 years ago. As prices rise, we need to earn more to stay in place and maintain the purchasing power of our money.

This is also true for investments. Ideally, we want to not only get our money back, but also earn more to maintain its value and future purchasing power – so we can buy groceries after retirement.

Because price movements are dynamic, there are a range of terms that describe various
conditions. Inflation, involves a general increase in prices. Disinflation describes the deceleration of the rate of inflation. Prices are still rising, but more slowly than before (like hitting the brakes when you see a police car on the highway). Some pundits warn of the risk of reflation – an acceleration of the inflation rate (think stepping on the gas). That’s not am concern for 2009 while we’re in recession. Inflation, measured by the consumer price index (CPI), rose 0.7% in June, largely due to higher energy prices, but declined 1.4% over the previous 12 months.

And then there are the extremes, which can wreak social and financial havoc. Deflation is a sustained decline in overall prices, last seen during the Depression. The recent drop in gasoline is welcome, but deflation can destroy wealth. In hyperinflation, prices rise so fast a currency becomes worthless. In 1923 Germany had postage stamp valued at 23 billion Marks; Zimbabwe’s inflation was estimated at 10 21 percent in late 2008.

Economists and policy makers strive toward a modest increase in inflation (roughly 2%
annually), believing it helps keep an economy growing steadily for longer. It’s like driving at the 25 mph speed limit on River Road – fast enough to get ahead, but slow enough so we can stay out of trouble and respond to the unexpected.


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