Inflation is good when it is mild. There are two situations where this occurs. The first is when inflation makes consumers expect prices to continue rising. When prices are going up, people want to buy now rather than pay more later. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. It creates a virtuous cycle, boosting economic growth.
The second is when it removes the risk of deflation. That’s when prices fall. When that happens, people wait to see if prices will drop more before buying. It cuts back demand, and businesses reduce their inventory. As a result, factories produce less and lay off workers. Unemployment rises, leading to wage deflation. Workers have less money to spend, which reduces demand even more. Businesses lower their prices. That makes deflation worse. For this reason, deflation is even more corrosive to economic growth than inflation. Prices fell 10% during the worldwide Great Depression.
- Inflation is good when it combats the effects of deflation, which is often worse for an economy.
- When consumers expect prices to rise, they spend now, boosting economic growth.
- An important aspect of keeping a good inflation rate is managing expectations of future inflation.
How the Fed Keeps Inflation Healthy
The Federal Reserve has set the official inflation target at 2%. On August 27, 2020, the FOMC announced it would allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for awhile.
That's for the core inflation rate. It strips out volatile gas and food prices. It is also the year-over-year rate, not the month-to-month rate. Former Fed Chairman Ben Bernanke was the first U.S. Fed chair to set an inflation target.
Inflation targeting spurs demand by setting people's expectations about inflation. They believe the Fed will make sure prices keep rising. That spurs them to shop now before prices rise even more.
The nation's central bank changes interest rates to keep inflation at around 2%. The Fed will lower interest rates to boost lending if inflation does not reach its target. The Fed will raise interest rates if inflation exceeds the Fed's target. Inflation targeting has become a critical component of monetary policy.
When Inflation Is Bad
If inflation is greater than 2%, it becomes dangerous. Walking inflation is when prices rise between 3% to 10% in a year. It can drive too much economic growth. At that level, inflation robs you of your hard-earned dollars. The prices of things you buy every day rise faster than wages. Thanks to walking inflation, it takes $24 today to buy what $1 did in 1913.
Galloping inflation occurred during the 1980s. It prompted President Ronald Reagan to famously say, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman." It took double-digit interest rates and a recession to stop galloping inflation. Thankfully, it hasn’t returned since then.
One reason inflation hasn’t returned is that the Fed understands the four causes of inflation much better than it did in the 1980s. It can more quickly put the brakes on rising prices by raising interest rates.
Examples of Inflation
The housing industry provides an example of both inflation and deflation. Until 2006, gradually rising prices attracted investors. They saw there was a chance to make money by buying now and selling later. This created more jobs as home builders tried to meet demand.
But between 2006 and 2010, the housing market experienced massive deflation. Prices fell by 30%. Those who could afford to buy a house decided to wait until the market improved. The longer they waited, the lower prices dropped.
Many people were trapped in their homes. They could not sell their homes for enough to cover the mortgages. They became upside-down. Eventually, they could not see any light at the end of the tunnel. Even those who could afford to keep paying, often just walked away. This sent prices even lower.
Others were counting on being able to sell their home in a year or so. They were relying on this to cover a mortgage they could not afford. They foreclosed and lost their home when they were unable to cover their loan. This happened to so many people that there was a glut on the market.
Homes that are left behind are called "shadow inventory," they were was not really absorbed until 2013.
Those who kept paying their loans had less money to spend on other things. This drove down demand in other sections of the economy. What did they get in return? An ever-deflating asset.