The Fundamentals of Inflation and How We Recover

What’s the biggest problem Americans face today? According to surveys, it’s not violent crime, illegal immigration, or even the war in Ukraine. It is inflation.¹ Inflation concerns are so great that a lot of people are rethinking financial decisions, big and small. Are you among them?

That might depend on what you know about inflation. The more we know about a subject, the more comfortable we might feel making decisions related to that subject. Hopefully, this also leads us to make smarter decisions.

Understanding the Basics of Inflation

So, how much do you know about inflation? Test your knowledge with this simple quiz covering the basics. Answers can be found at the end of the article.

True or false:

1. Inflation measures price increases in goods and services over time.
2. Inflation can be measured by an increase in the cost of one product or service.
3. Inflation is caused by insuf­fi­cient goods and services to meet high demand and a growing money supply.
4. When inflation is high, the Federal Reserve typically lowers interest rates.
5. The Federal Reserve strives to achieve a long-term inflation rate of 3 to 5% to maximize employment and keep prices stable.
6. Suppose the price of goods doubles over the next 10 years. If your income also doubles, you’ll be able to buy more in the future than you can buy today.
7. Inflation that is too low can weaken the economy.

Were you surprised by any of the answers? Even if you scored 100%, it’s still easy to overlook the facts when inflation anxiety creeps in. And anxiety can cloud our judgment and affect our ability to make clear financial decisions.

Understanding Inflation in Context

Those familiar with inflation in the 1970s might wonder how today’s environment compares to that period. The great inflation of the 1970s began with the Nixon administration’s 1971 decision to abandon the dollar’s peg to gold. The resulting loss of confi­dence in the dollar took 10 years to run its course. The deval­u­ation of the dollar reduced world demand, causing excess dollars to be unloaded and fueling a decade of painfully high inflation. The supply of money—as measured by a calcu­lation called M2²—grew at a rapid pace (8–10% per year) throughout those 10 years. It took Fed Chairman Paul Volcker four years and two reces­sions to bring inflation down.

Today’s inflation factors are different. The enormous money supply in part results from COVID-related stimulus spending, amassing an unprece­dented increase in spendable money (M2) held by the public. In February 2021, M2 was growing at 26.9%. Inflation started rising a year later when it appeared the COVID threat was receding. Fortu­nately, in the last three months, the annualized growth of M2 has fallen to 1.3%, which effec­tively removes a signif­icant source of future inflation, making the Fed’s job of curbing inflation easier.

The classic defin­ition of inflation is too much money chasing too few goods. To address today’s inflation, the Federal Reserve is already at work on the too much money side of the equation. The too few goods side is more compli­cated. American businesses have been dealing with shortages of material and labor since the economy reopened following COVID shutdowns.

Employers are pulling out all the stops to draw workers. Hiring incen­tives include starting pay boosts, raises and bonuses to retain staff, and greater flexi­bility for workers. Companies are also investing in automation, which saves production costs during shortages and can ensure raw materials are best utilized. They’re also seeking alter­native suppliers and investing in ways to bring manufac­turing in-house. The labor and material shortage is a big problem that will take time to address, but it is solvable. And American businesses have already been working on solutions since 2020.

There is no easy way to fix inflation. It requires businesses to address the supply chain and labor shortages. It also requires the Fed to decrease the excess supply of money, which takes time. Fed Chairman Jerome Powell said at his confir­mation hearing, “Tackling inflation is my top domestic priority. We will bring the skill and knowledge needed at this critical time for our economy and families across the country.”

Rick’s Insights:

• Surveys confirm that Americans believe inflation is our biggest problem today.
• The annualized growth of the money supply has fallen to 1.3%, which bodes well for future inflation.
• Employers are offering hiring incen­tives to address current labor shortages.

Quiz answers:

1. True. The Fed says, “Inflation is the increase in the prices of goods and services over time.”³
2. False. The Fed says, “Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy.”⁴
3. True. The Fed says, “Inflation is caused when the money supply in an economy grows at a faster rate than the economy’s ability to produce goods and services.”⁵
4. False. The Fed says, “When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.”⁶
5. False. It is 2%. The Fed says, “The Federal Open Market Committee (FOMC) judges that inflation of 2% over the long run is most consistent with the Federal Reserve’s mandate for maximum employment and price stability.”⁷
6. False. If both your income and prices double in 10 years, you will be able to buy the same amount you’re able to buy now.⁸
7. True. The Fed says, “When inflation runs well below its desired level, house­holds and businesses will come to expect this over time, pushing expec­ta­tions for inflation in the future below the Federal Reserve’s longer-run inflation goal. This can pull actual inflation even lower, resulting in a cycle of ever-lower inflation and inflation expec­ta­tions. If inflation expec­ta­tions fall, interest rates would decline too. In turn, there would be less room to cut interest rates to boost employment during an economic downturn.”⁹