Most people have some basic understanding about inflation. As consumers we are making purchases of various items, so we are aware of what things cost, at least from the perspective of items that we are purchasing.
To determine the rate of inflation, it is necessary to not only know what things cost at the present time, but what these same items cost in a prior period. The change in prices between the present and prior periods will determine the rate of inflation.
The December 2016 Consumer Price Index (CPI) report, for the past 12 months showed prices increasing at 2.1%. Excluding food and energy, the 12-month increase was 2.2%.
Some might wonder why food and energy are oftentimes considered separately in the calculation. That is because food and energy prices are quite volatile, and change frequently. A large swing in either food or energy prices can sometimes cause a disproportionate impact on the overall index. Most other items included in the CPI index do not change as frequently, as food and energy.
The significance of an inflation reading over 2% is that the Federal Reserve (Fed) has been targeting an inflation level of 2.0%. There are other inflation measures that the Fed looks at besides the CPI, but an increase in the inflation rate gets the Fed’s attention.
In recent years inflation, as measured by the CPI excluding food and energy, has tended to be increasing a little below 2%. The most recent report does signify that inflation is starting to increase at a faster rate.
Inflation is normally perceived to be a bad thing. No one wants to pay higher prices. However, inflation is not necessarily a problem, if one’s income is keeping up with inflation, and if the rate of inflation is anticipated.
Recipients of Social Security receive adjustments based on changes in the CPI index, as do many workers receiving government pensions. Likewise some union contracts have wage rates adjusted to the CPI index, and some rent increases also might have these kind of adjustments.
For most workers whose pay is not tied to a contract it is important to have some knowledge of what the inflation rate is. If someone does not receive a raise, even when inflation is relatively low at 2%, that worker is falling behind. If a worker receives a 3% raise with 2% inflation then the inflation adjusted increase is 1%.
Inflation is an important consideration for people who are borrowing money versus those who are receiving interest payments. Higher inflation is good for a borrower who has a fixed rate loan, as that person will be paying back money worth less. For a saver higher inflation is a negative.
Someone with a 4% mortgage, who is in a combined 40% tax bracket for state and federal has an after tax interest cost of 2.4%, or just slightly above the current rate of inflation. After adjusting for inflation that person is virtually receiving an interest free loan. For the saver, who is receiving interest, there is a good chance after taxes and inflation that person could actually be losing money.
It should be noted that when looking at the inflation rate, the number is based on a composite for the entire country. Someone’s own personal inflation rate could be significantly different versus the national average. For example in our local area, if someone is paying 40% of their income on rent, and rents are going up at 5%, their personal inflation rate is likely higher than the national average.
What goes into the inflation rate is a combination of goods and services. The price of services have been typically rising at a faster rate than the price of goods. For goods there have typically been significant productivity improvements over time, and a stronger U.S. dollar also helps to keep the cost of imported goods lower. The change in the price of services is more dependent upon changes in wage rates.
The recent increase in the rate of inflation will likely be a start of a trend of somewhat higher inflation, but the changes will be gradual. However, it is very unlikely that we will see inflation approaching levels that were experienced in prior decades. With wage rates and interest rates both rising the overall impact of higher inflation should not be too significant for most people.