by: Richard A. Anderson, CFA
Usually inflation lurks in the background, going unnoticed as it slowly erodes the purchasing power of our money. For this reason, it is often referred to as the silent thief or silent killer. Even though you don’t see it, it’s there.
In simplest terms, inflation is a general rise in price levels. It means your current dollars will buy less goods and services in the future.
Is Inflation Good or Bad?
Given how inflation erodes the purchasing power of our money, you may be thinking inflation is bad. Many economists, however, maintain that moderate inflation levels are good for the economy. Moderate inflation is needed to drive consumer spending, which is critical for economic growth. This is why the Fed targets a 2% inflation rate as part of its mandate to promote stable prices.
The Good Side to Inflation
Stable, moderate inflation is associated with a healthy economy. As an economy grows, consumers and businesses spend more money on goods and services. Demand exceeds supply and producers raise prices. This is inflation. Therefore, rising prices can be considered a good thing.
But prices that rise too much or prices that fall are bad.
The Bad Side to Inflation
When prices increase rapidly, consumers anticipate those price increases to continue into the future. Higher prices mean consumers will buy more goods and services now to avoid paying a higher price in the future. As a result, demand grows even faster and producers continuously raise prices. This upward price spiral is sometimes referred to as runaway inflation or hyperinflation.
What is Deflation?
On the other hand, when prices fall it can result in a negative feedback loop. If prices fall consistently, consumers will hold off on making purchases today in hopes those goods and services will be cheaper in the future. As a result, demand falls and producers continuously lower prices to try to attract buyers. This downward price spiral is referred to as deflation.
Stable, moderate price increases encourage spending and economic growth. Consumers buy more goods and services, which causes companies to increase production. Companies hire more workers to meet the increased demand, which results in lower unemployment and higher wages for workers.
Contrarily, periods of drastic price change can result in a boom or bust economy. For example, runaway inflation can cause overproduction and over hiring, as demand for goods and services can only increase for so long. Eventually, companies decrease production and lay off workers, causing the unemployment rate to increase and wages to decrease.
Inflation’s Impact on Borrowers
In addition to its impact on supply and demand, inflation can also have an effect on borrowers. Inflation is beneficial for those who borrow at a fixed rate because borrowers are paying back their loans with less purchasing power over the term of the loan. Conversely, deflation is better for the lender than borrower.
The chart below shows the corrosive power of inflation over long periods of time.
Another way of showing the effect of inflation is by showing the price of a movie ticket over time.
In recent history, inflation has been relatively benign. However, it has been more pronounced in medical treatment, secondary education, and childcare. Electronics have been an area where prices have come down dramatically. Remember when a computer or tv used to cost an arm and a leg? That’s not the case anymore.
As a side note, perhaps the reason we haven’t fully appreciated the benefits of recent low overall inflation is because essential goods and services have increased in price. Medical care, secondary education, and childcare are ongoing expenses rather than one-time purchases.
The question of whether inflation is good or bad may seem paradoxical. Why would you want prices to rise over time and pay more for something in the future? The answer is because it’s better than the opposite. Some inflation is good. Too much or too little can be bad.
Author’s Bio
Richard A. Anderson is a portfolio analyst at HIGHLAND Financial Advisors, LLC based out of Wayne, NJ. HIGHLAND Financial Advisors, LLC is a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management services to help clients focus on what matters most to them.
Richard graduated from Ramapo College of New Jersey where he earned a Bachelor of Science degree in Business Administration with a concentration in Finance. Richard joined the firm in June 2013 and is responsible for assisting HIGHLAND’s Wealth Advisors in developing portfolios to help individuals, families, and institutions reach their financial goals. He is a Chartered Financial Analyst (CFA) charterholder and member of CFA Society New York. For more of Rich’s thoughts on the markets and sports, follow him on Twitter and connect with him on LinkedIn.