Inflation Equals Thievery

$100 placed at 7 percent interest compounded quarterly for 200 years will increase to more than $100,000,000—by which time it will be worth nothing. Robert A. Heinlein—Time Enough for Love, 1974.

Many people ask, What is inflation?

Inflation is defined by Webster’s Dictionary as “a general rise in prices brought about by an increase in the ratio of currency and credit to the goods available.” When the general price level rises, each unit of the functional currency buys fewer goods and services; consequently, inflation is a decline in the real value of money—a loss of purchasing power in the medium of exchange. A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index (normally the consumer price index) over time. So next time someone asks you, what is inflation, we hope this page will allow you give a clear answer.

Inflation is simply the decline in purchasing power of money. It redistributes wealth from savers and lenders to borrowers. The value of savings declines, but so does the value of debt. Conversely, in a deflationary environment, the purchasing power of your money rises, and wealth is transferred from borrowers to savers and lenders. The value of your savings rises, but so does the value (burden) of your debt.

Inflation is often referred to as a “hidden tax” because it is so difficult to see what is occurring to the purchasing power of your money. The chart on the following page, courtesy of Kenneth Landon, compares the purchasing power of gold to the U.S. dollar since 1793.

In most economic textbooks, inflation is usually discussed within the context of a normal business cycle and consists of two types:

• Cost-Push Inflation: Persistently rising general price levels brought about by rising input costs. In general, there are three factors that could contribute to cost-push inflation: rising wages increases in corporate taxes, and imported inflation (when imported raw or partly-finished goods become more expensive, often as a result of currency depreciation).
• Demand-Pull Inflation: This theory can be summarized as “too much money chasing too few goods.” In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.

CPI Composition

The Consumer Price Index is composed of a basket of goods and services that is measured on a monthly basis. The current CPI basket has the following composition:

As shown in the chart above, Housing (Owner’s Equivalent Rent) makes up over 40 percent of the index. The next largest item is Transportation at 16.6 percent. As a result, the monthly reported CPI numbers are heavily influenced by the Housing component of CPI. The main point of this discussion is that weakness in Housing CPI can easily mask what is happening in other categories.

CPI Trends

The government reports CPI numbers monthly in two ways: the normal “headline” CPI and “core” CPI (which excludes food and energy). This differentiation was put in place in an effort to evaluate CPI results without the more volatile food and energy components. However, I believe we would all agree that food and energy costs are critical components of CPI, and they are the main drivers of inflation expectations for most people.