5 things to know about inflation with Weatherhead's Jonathan Ernest | Weatherhead School at Case Western Reserve University

5 things to know about inflation with Weatherhead's Jonathan Ernest

Posted 6.23.2022

5 things to know about inflation with Weatherhead's Jonathan Ernest

This story originally ran in the daily.

Scan today’s headlines, fill up your car’s tank with gasoline, and even listen to the water-cooler banter in the office. You will most likely see, hear and feel the impact of the word, “inflation,” in your daily life.

On June 15, the Federal Reserve announced that it would raise interest rates by 0.75%, in an effort to curb the faster-than-expected rise of inflation. This is the highest rate hike since 1994.

The Federal Reserve’s decision lifts short-term borrowing costs to a target range between 1.50% and 1.75%. Throughout the year, more interest rate hikes are expected to be announced. These increases will make taking out a loan to buy a home or expand on a business more expensive.

What does this all mean?

We sat down with Assistant Professor of Economics Jonathan Ernest to learn more about inflation and how it will impact your bottom line.

1. When you hear about “inflation” in the news, it is typically referencing an increase in the Consumer Price Index (CPI).

Inflation describes increasing prices, but there are often misconceptions about whether this means one good, all goods, or somewhere in between. Goods and services go up (or down) in price all of the time, to balance supply and demand. When you go to the supermarket and see that chicken wings are more expensive this week (perhaps because of a decrease in supply due to an avian influenza outbreak), that doesn’t necessarily mean that you’re experiencing inflation.

Similarly, if we look at the relative price of all goods and services we might see rises in prices for many items that don’t have a real impact on your household budget, such as rocket engines.

What CPI does is to create a basket of goods that falls somewhere in the middle, and represents the purchases of the average household. It then compares how much that same basket of goods costs this month versus a year ago. This gives us a better idea of how your budget is impacted by rising prices.

2. As of May 2022, the U.S. annual inflation rate is 8.6%.

This means that buying the same basket of goods as the average U.S. consumer in May 2022 would cost 8.6% more than those same goods in May 2021. This was the highest rate we’ve seen in approximately four decades. Economists had expected this number to be a bit lower this month, as prices were already elevated in May 2021, so the increase is off of a larger base.

We can also look at changes in prices for the basket of goods that producers typically purchase using the Produce Price Index (PPI), which rose 10.8% in May 2022 compared to May 2021. This may indicate continued increases in prices for consumers in the future, as the cost of producing and delivering those goods continues to rise.

3. What is causing prices to rise?

Monetary economist, Milton Friedman, famously said, “Inflation is always and everywhere a monetary phenomenon.” In the long run, if the more dollars there are to purchase the same number of goods, the more the prices of those goods will increase to ration scarce resources to those who value them most. However, there are several potential explanations for what may be causing our current price hikes.

Demand rebounded quickly and has remained high following the onset of COVID-19 lockdowns. This demand has been further spurred on by fiscal policies, which injected trillions of dollars into the U.S. economy, keeping consumers afloat but keeping prices high.

Then there are issues on the supply side. From COVID-19-induced supply-chain disruptions, to COVID-19-based lockdowns in China, it has been more expensive and difficult to produce a variety of goods.

Finally, there’s Russia’s war in Ukraine and the resulting sanctions and disruptions to the production and supply of oil and crops. Each of these factors could contribute to higher prices for consumers in the U.S.

4. Inflation does not impact everyone equally, but unexpected inflation creates difficulties.

Low levels of inflation tend to be rather predictable. High levels of inflation, however, can have much more variability, and can discourage economic activity.

Let’s say you are considering buying a house, and your friend might be willing to lend you the money to do so. Your friend is going to charge you some interest for a few reasons. One is that there is some risk that you won’t be able to pay back the loan. A second reason is that your friend needs to be compensated for delaying the satisfaction she could have from buying things today, and forgoing that consumption until a future time. And most importantly for our topic of inflation, any inflation experienced between today and when you pay back the loan means the dollars you pay back won’t buy as many goods as they would today.

If you and your friend could perfectly predict how much inflation there would be, then it’s easy to add that to the interest charged and find an agreeable deal for the loan. But if inflation is high (and therefore more variable), there’s a large risk of incorrectly estimating the rate of inflation, creating winners and losers in the trade.

If your friend lent you money expecting 2% inflation, but inflation was actually 8.6%, you got a terrific deal but your friend would lose out.

Because high rates of inflation can be painful, the Federal Reserve is attempting to reduce inflation by pushing up interest rates, which discourages demand and helps lower prices. However, they risk slowing the economy so much that they could bring on a recession. The hope is that the Federal Reserve can get a handle on inflation while creating a “soft landing” where the economy only slows a bit and avoids falling into a recession.

5. You may have experienced “Shrinkflation.”

Most consumers have noticed increasing prices when filling up their gas tanks or checking out at the supermarket. But there’s a subtle way in which companies may attempt to deal with increasing costs, without shocking consumers with even higher prices.

Deemed “shrinkflation,” this is the practice of lowering the quality or amount of a good or service, rather than raising the price. Whether it’s reducing one order of chicken wings to include only 8 wings instead of 10, or shrinking the “party size” bags of Fritos Scoops from 18 to 15.5 ounces, many companies are opting to provide less for the same price, rather than providing the same amount for more money. Which means that while you may be paying a bit more for your weekly cart of groceries, you’re likely receiving a bit less in that cart as well.

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