What Is Inflation—And Why Is Everyone Talking About It? What is inflation, and is it something to worry about? A lot of the thinking surrounding inflation has changed over the years, and economists disagree on what causes it and how much weight the federal government and Federal Reserve should give it when it sets fiscal and monetary policies. Here’s a closer look: What is inflation? Inflation refers to a general increase in the price of goods and services, so each dollar has less purchasing power over time. Most economists say a small amount of inflation is necessary. If an economy isn’t already using all of its labor and resources to produce as much as it can, then a little inflation theoretically boosts productivity. The Federal Reserve, which is responsible for U.S. monetary policy, has targeted an annual inflation rate of 2%. However, high inflation, which causes a rapid devaluation of currency, creates economic problems for households and markets, including: - A drop in real wages. When prices rise more quickly than wages, real incomes drop.
- Rising inequality. Poor households, with few tangible assets, are more vulnerable than affluent households that own property and other inflation-resistant investments.
- Economic uncertainty. When businesses don’t know what future costs will be, they make fewer capital investments, slowing down the economy.
- Less competitive domestic goods. Runaway inflation can cause the nation’s consumers to buy more imported goods and foreign consumers to buy fewer of the country’s exports.
- Rising unemployment. As prices increase, businesses may try to reduce costs by employing fewer people.
The Federal Reserve often tries to curb inflation by raising interest rates, but doing so comes with its own economic consequences. Namely, the cost of borrowing rises, leaving consumers with less money to spend. In return, businesses lower prices to attract buyers. Though this can slow inflation, a drop in consumer spending can also slow down the economy, perpetuating one of the negative effects of runaway inflation. Should we worry about rising inflation? Economists disagree over whether that’s cause for alarm. That’s partly because the last few decades have challenged the conventional wisdom on inflation. Low unemployment rates have historically been associated with high inflation, although this link began to deteriorate in the late 1980s. And following the Great Recession, inflation remained almost obstinately stable against fast jobs gains. While some economists see big government spending, low interest rates and hordes of post-pandemic American consumers eager to spend as a recipe for disaster, others are less concerned. The reasons they give are varied. Stable inflation over the last few decades may signal that central banks have mastered monetary policy (not likely in my view), making it less likely in general for inflation to get out of control. Perhaps the current spike in inflation will be a temporary issue, as the economy snaps back to pre-pandemic levels of activity. Some argue that even if high inflation represents a real economic risk, the risk of keeping so many unemployed and without economic relief is far greater. Inflation is a fact of modern economic life. When it’s kept below a manageable threshold, it can be a good thing. However, you can expect that inflation will remain a hot topic of discussion as the economy finds its new normal. In my view, regardless of economists disagreement, inflation will be a consistant issue, even if it is “small”. It must be taken into consideration when investing. So how can one manage the inflation issue? Study the historical values of various investments to assist in asset allocation. Take into consideration not only inflation, but taxes; the two main issues that hurt spending power over time. Finally, endeavor to match asset allocation with financial goals, tax situation, and risk profile. Sound like fun? If not, contact us to help in the process.
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