If you think of the economy as a closed system then inflation doesn't hurt people in and of itself. Every extra dollar spent is someone else receiving an extra dollar. When most people think about inflation, the mistake they make is they forget that inflation pushes up their own incomes. —Scott Sumner, an economist who teaches at Bently University in Waltham, Mass.
Matt Towery and his wife were recently grocery shopping in Atlanta and noticed that prices seemed higher.
"My money was just not getting anywhere near what it was 2 or 3 years ago," he recalls.
For example, Towery, a conservative syndicated columnist, noticed in June of 2003 that a pound of ground chuck beef sold for $2.23. This year it goes for $3.40. Kiplinger's Personal Finance magazine predicts that grocery prices will go up 4 percent this year.
Yet, according to the government's Consumer Price Index, compared to a year ago, all prices are only up 2 percent. If you take out gas and food prices (which are more volatile in their price fluctuations), core inflation is only up 1.7 percent.
Others worry that as the economy continues to rebound, inflation will rise. But experts are divided over whether that would be a bad thing. Some economists say a certain amount of inflation is a good thing.
"There is no inflation problem in the U.S. today," Merrill Lynch's Ethan Harris told Bloomberg. "It sounds kind of crazy, but we are actually too low on inflation."
Although there were double-digit inflation spikes in the 1970s, from 1982 to 2012 the average yearly increase in the price of consumer goods has been 2.9 percent.
"We keep being told that inflation is low," Towery says. "The flip side of that is there are no substantial increases in wages or your ability to receive a good return for a stable investment."
Demand and supply
Economists tend to think of inflation in two different ways.
One is "demand side" where people are spending more money, which drives up prices. "That is what causes extreme inflation that you may read about happening in other countries," says Scott Sumner, an economist who teaches at Bentley University in Waltham, Massachusetts.
The other type of inflation is "supply side." If something happens to reduce the supply of goods to the economy — such as a natural disaster or an oil embargo — that will tend to raise prices and reduce living standards.
"Supply side inflation is the only type of inflation that hurts consumers as a group," Sumner says.
A closed system
Inflation can rise due to a shrink in supply. A drought, for example, can decrease the amount of wheat. The demand stays the same, however, and the price in bread goes up. Food items are one area that are particularly sensitive to this type of supply variance.
But aside from sudden and unpredictable drops in the supply, inflation normally will raise not just prices, but also incomes. People may be paying more for items, but the people selling the items are also earning more revenue.
"If you think of the economy as a closed system," Sumner says, "then inflation doesn't hurt people in and of itself. Every extra dollar spent is someone else receiving an extra dollar. When most people think about inflation, the mistake they make is they forget that inflation pushes up their own incomes."
If the inflation rate is reduced to a lower level, that would also reduce the rate at which wages and salaries are rising by the same amount. "So it wouldn't really help the public in the way they think," Sumner says. "They are likely to think the salary they get is somehow separate from the question of how fast prices are rising. They don't see the connection. So they look of inflation as a bad thing."
For example, Sumner remembers when gas was 32 cents a gallon.
But he also remembers when the minimum wage was $1.25 an hour. "Everything was lower," he says. "It raises the question of whether inflation matters at all."
Why a little inflation is good
Sumner says a little bit of inflation "greases the wheels" of the marketplace by making it easier to adjust people's real wages (the actually buying power of the salary) without having to adjust their nominal wage (the dollar amount).
For example, a worker may get a 3 percent raise in her wages, but inflation may have made the value of those dollars worth 4 percent less — leaving her with a 1 percent drop in real wages. It seemed like a raise, but it wasn't.
"If there was no inflation in the economy and you gave people a 3 percent pay cut, they would probably be outraged," Sumner says. "But if you have 8 percent inflation and they got a 5 percent raise that would be the exact same thing. They got a 3 percent pay cut in real terms. But they are not quite as outraged because they think they are getting more money. They don't blame the firm, they blame the economy. They think, 'Well, at least the firm gave us a 5 percent raise.'"
Sumner calls this a money illusion.
Why high inflation is bad
"High inflation really hurts savings and investment and kind of distorts the economy," Sumner says. "The higher the rate of inflation the more you tend to rip off people who are thrifty and save and invest. This is partly because you are taxing them on gains that are actually inflated — they are not real gains."
For example, in the 1970s high inflation was hard on savers.
"High inflation is bad, because it punishes savings and investors too much," Sumner says.
Affecting the economy
In normal times, the Fed tries to help the economy by taking action to reduce the inflation rate to 2 percent.
"The Fed has been doing this for a long time, but it was never controversial," Sumner says. "The reason it was never controversial was that they were very rarely ever in the position of trying to raise the inflation rate. They were usually trying to lower it down to the 2 percent."
"Back in 2010 when Ben Bernanke, chairman of the Federal Reserve, announced that he was trying to raise inflation, he ran into a real buzzsaw of criticism," Sumner says, "because is sounded bad to the average person."
Sumner says the average person thought raising inflation would reduce their standard of living. Sumner says the opposite was true. Because we were in a recession, a higher inflation can only be generated by the Federal Reserve pumping up what's called aggregate demand in the economy — trying to create a boom condition in the economy. "That would have put more people back to work," Sumner says. "Americans would have been better off. But because the Fed ran into so much criticism, they backed off on the policy."
The result is we still have less than 2 percent inflation today.
The normal policy tool used by the Federal Reserve is lowering and raising interest rates for banks. The banks then, in turn, would lend out money at higher interest rates. When the Federal Reserve's interest rates fell to zero, they couldn't lower the rates any more. This led to another way of affecting the economy called quantitative easing.
Quantitative easing is a way of affecting the money supply by printing more dollars and, by buying bonds with that money, depositing that money in banks. This gives the banks more money to lend out. The more money lent out, the greater the money supply and the greater the inflation.
"In normal times doing this sort of increase in the quantity of the money supply would be very inflationary, Sumner says. "It would even be hyper inflationary," he says. "That is absolutely correct."
But in normal times, interest rates are positive.
"Cash is like a hot potato," Sumner says. "Cash doesn't earn any interest. So when you get cash, you want to get rid of it because you can earn better rates of return on other assets during normal times. You don't want to hold all your wealth in cash."
Investments have a better return than currency.
Normally if the Federal Reserve injects currency into the economy, people will try to get rid of it, which will drive up prices which will make it worth less.
But when the interest rates that the Federal Reserve charges banks is zero, (and this has only been in the last 5 years and also during the Great Depression) money will often just sit in the banks' reserves and doesn't have its normal inflationary affect.
What could be done if prices started rising fast? The Fed could very easily take the money right back out of circulation, Sumner says.
If the money is moving out into the economy too fast, they could raise the interest rate they pay banks for holding these reserves of cash.
"I'm not actually worried about inflation," Sumner says. "I know it seems kind of scary when you look at it from a simple money inflation point of view,
"I'm a strong believer in the view that printing a lot of money normally causes a lot of inflation," Sumner says, "but the Fed has a lot of tools to prevent that from happening."19 comments on this story
Matt Towery in Atlanta, however, still sees a disconnect between official inflation rates and the challenges the average American faces.
"The problem is we don't have a system that looks at the true cost impact that families and consumers must deal with," Towery says.
Sumner admits that there are ups and downs in prices.
"Consumers notice the ones that go up," he says, "but not the ones that go down."