Inflation occurs when the prices of goods and services increase. There are four main types of inflation, categorized by their speed. They are "creeping," "walking," "galloping," and "hyperinflation." There are specific types of asset inflation and also wage inflation. Some experts argue that demand-pull (also known as "price inflation") and cost-push inflation are two more types, but they are causes of inflation. So is the expansion of the money supply.
Creeping or mild inflation occurs when prices rise by 3% or less per year. According to the Federal Reserve, when prices increase by 2% or less, it benefits economic growth. That kind of mild inflation makes consumers expect that prices will keep going up, which boosts demand. Consumers buy now in order to beat higher future prices. That's how mild inflation drives economic expansion. For that reason, the Fed sets 2% as its target inflation rate.
This strong, or destructive, inflation is between 3% and 10% per year. It is harmful to the economy, because it heats up economic growth too quickly. People start to buy more than they need, to avoid tomorrow's much-higher prices. This increased buying drives demand even further so that suppliers can't keep up. More important, neither can wages. As a result, common goods and services are priced out of the reach of most people.
When inflation rises to 10% or more, it wreaks absolute havoc on the economy. Money loses value so quickly that business and employee income can't keep up with costs and prices. Foreign investors, in turn, avoid the country where this occurs, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. Galloping inflation must be prevented at all costs.
Hyperinflation occurs when prices skyrocket by more than 50% per month. It is very rare. In fact, most examples of hyperinflation occur when governments print money to pay for wars. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s. The last time the United States experienced hyperinflation was during the Civil War.
Stagflation occurs when economic growth is stagnant but there still is price inflation. This combination seems contradictory, if not impossible, though. Why would prices go up when there isn't enough demand to stoke economic growth?
This phenomenon happened in the 1970s when the United States abandoned the gold standard. Once the dollar's value was no longer tied to gold, it plummeted. At the same time, the price of gold skyrocketed.
Stagflation didn't end until Federal Reserve Chairman Paul Volcker raised the fed funds rate to the double-digits. He kept it there long enough to dispel expectations of further inflation.
The core inflation rate measures rising prices in everything except food and energy. That's because gas prices tend to escalate every summer. Families use more gas to go on vacation. Higher gas costs increase the price of food and anything else that has high transportation costs.
The Federal Reserve uses the core inflation rate to guide it in setting monetary policy. The Fed doesn't want to adjust interest rates every time gas prices go up. In January 2022, the all-items (less food and energy) index rose 6.0 percent, the largest 12-month change since the period ending August 1982.
Deflation is the opposite of inflation. It's when prices fall. It's caused when an asset bubble bursts.
That's what happened in housing in 2006. Deflation in housing prices trapped those who bought their homes in 2005. In fact, the Fed was worried about the overall deflation during the recession. That's because deflation can turn a recession into a depression. During the Great Depression of 1929, prices dropped by 10% per year. Once deflation starts, it is harder to stop than inflation.
Wage inflation occurs when workers' pay rises more rapidly than the cost of living. It happens in three situations. The first is when there is a shortage of workers. The second is when labor unions negotiate ever-higher wages. The third is when workers effectively control their pay.
A worker shortage occurs whenever unemployment is below 4%. Labor unions negotiated higher pay for autoworkers in the 1990s. CEOs effectively control their pay by sitting on many corporate boards, especially their own. All of these situations creat wage inflation.
Of course, everyone thinks their own wage increases are justified, but higher wages are one element of cost-push inflation. That can drive up the prices of a company's goods and services.
An asset bubble, or asset inflation, occurs in one asset class. Good examples include housing, oil, and gold. It is often overlooked by the Federal Reserve and other inflation-watchers when the overall rate of inflation is low. But the subprime mortgage crisis and subsequent global financial crisis demonstrated how damaging unchecked asset inflation could be.
Gas prices rise each spring in anticipation of the summertime vacation driving season. In fact, you can expect gas prices to rise ten cents per gallon each spring. But political uncertainty in the oil-exporting countries drove gas prices higher in 2011 and 2012. Prices hit an all-time peak of $4.06 in July 2008, thanks to economic uncertainty.
What do oil prices have to do with gas prices? A lot. In fact, oil prices are responsible for about two-thirds of gas prices. The rest is distribution and taxes. They aren't as volatile as oil prices.
Crude oil prices hit an all-time high of $145.31 a barrel in July 2008. This inflation-adjusted price was despite a decrease in global demand and an increase in supply. Commodities traders determine oil prices. Those traders include both speculators and corporate traders who are hedging their risks. Traders bid up crude oil prices in two types of situations. The first is if they think there are threats to supply, such as unrest in the Middle East. The second is if they see an uptick in demand, such as growth in China.
Food prices soared 6.4% in 2008, causing food riots in India and other emerging markets. They spiked again in 2011, rising by 4.8%. High food costs led to the Arab Spring, according to many economists. Food riots caused by inflation in this important asset class could reoccur. As of January 2022, food prices have increased by 7% in the United States, reflecting the highest food inflation we have seen in forty years.
An asset bubble occurred when gold prices hit the all-time high of $1,895 per ounce on September 5, 2011. Although many investors might not call this inflation, it sure was. That's because prices rose without a corresponding shift in gold's supply or demand. Instead, investors ran to gold as a safe-haven. They were concerned about the declining dollar. They felt gold protected them from hyperinflation in U.S. goods and services. They were uncertain about global stability.
What spooked investors? In August, the jobs report showed absolutely zero new job gains. During the summer, the eurozone debt crisis looked like it might not get resolved. There was also stress about whether the United States would default on its debt. Gold prices rise in response to uncertainty. Sometimes, it's to hedge against inflation. Other times, it's the exact opposite, the resurgence of recession.
Frequently Asked Questions (FAQs)
How do you hedge against inflation?
Investors have many strategies for how to beat inflation, but as with any investment, there is an element of uncertainty and risk with all inflation hedges. For example, bond investors can hedge for inflation with Treasury Inflation-Protected Securities (TIPS) that automatically adjust payments to account for changes in the Consumer Price Index (CPI). Others try to invest in precious metals or other commodities that could increase in value as inflation rises.
How do you calculate the inflation rate?
The CPI is one of the most closely watched gauges of inflation. The government calculates this figure by measuring price changes for key goods and services. The average person probably doesn't have access to the data to calculate these measurements themselves, but anyone can calculate inflation expectations by comparing TIPS to other Treasury securities that aren't inflation-protected. To calculate inflation expectations, subtract a Treasury yield from a TIPS yield with the same maturity date.