How to Understand Inflation Like a Pro (Even If You’re Not an Economist)

Do you want to learn how to understand inflation like a pro, even if you’re not an economist? In this blog post, I’ll show you how to peel the inflation onion and reveal its different layers, and how to apply this knowledge to your own financial situation. #inflation #economics #finance

How to Understand Inflation Like a Pro (Even If You’re Not an Economist)
Photo by Joachim Schnürle / Unsplash

Inflation is one of the most important and complex topics in economics. It affects everything from your purchasing power, to your savings, to your investments, to your standard of living.

But do you really understand what inflation is, how it is measured, and what causes it to change?

If you’re like most people, you probably have a vague idea of inflation as the general increase in prices over time.

You may also know that inflation is influenced by factors such as supply and demand, monetary policy, and global events.

But do you know how to peel the inflation onion and analyze its different layers?
Do you know how to interpret the various indicators of inflation and inflation expectations?
Do you know how to adjust your financial decisions according to the inflation outlook?

If you answered no to any of these questions, don’t worry. You’re not alone.

Inflation is a notoriously difficult concept to grasp, even for experts.

It is often shrouded in jargon, statistics, and technicalities that make it hard to follow and relate to. That’s why many people feel confused, frustrated, or bored when they try to learn about inflation.

But it doesn’t have to be that way.

In this blog post, I’m going to show you how to understand inflation like a pro, even if you’re not an economist.

I’m going to explain inflation in simple and clear terms, using real-world examples and stories that will make it easy and fun to learn.

I’m going to teach you how to peel the inflation onion and reveal its different layers, how to use the tools and methods that central bankers use to measure and monitor inflation, and how to apply this knowledge to your own financial situation.

By the end of this blog post, you will have a solid grasp of inflation and its implications for your life.

You will be able to read and interpret inflation reports, charts, and forecasts with confidence and ease.

You will be able to make smarter and more informed decisions about your spending, saving, investing, and borrowing.

You will be able to impress your friends, family, colleagues, and boss with your newfound expertise on inflation.

Are you ready to become an inflation pro? Let’s get started!

What is Inflation?

Inflation is the general increase in the prices of goods and services over time. It means that your money loses some of its purchasing power as time goes by. For example, if the annual inflation rate is 3%, it means that a basket of goods and services that cost $100 today will cost $103 next year.

Inflation is not necessarily a bad thing. A moderate and stable level of inflation can be beneficial for the economy, as it encourages consumption, investment, innovation, and growth. It also allows for some flexibility in wages and prices, which can help adjust for changes in supply and demand.

However, inflation can also be harmful if it is too high or too low, or if it is unpredictable or volatile.

High inflation can erode the value of money and savings, distort relative prices and incentives, reduce economic efficiency and productivity, create uncertainty and instability, and undermine confidence and trust.

Low inflation can also have negative effects, such as reducing demand and output, increasing debt burdens, creating deflationary expectations and downward price spirals, limiting the effectiveness of monetary policy, and increasing inequality.

Therefore, one of the main goals of monetary policy is to achieve price stability, which means keeping inflation at a low and stable level over time. The Federal Reserve has set a 2% longer-run goal for inflation based on a specific measure called the personal consumption expenditures (PCE) price index.

How is Inflation Measured?

There are many ways to measure inflation, depending on what goods and services are included in the calculation, how they are weighted according to their importance or frequency of consumption, and how they are adjusted for quality changes or seasonal variations.

The most common measure of inflation in the U.S. is the consumer price index (CPI), which tracks the changes in prices of a representative basket of goods and services purchased by urban consumers. The CPI includes items such as food, housing, transportation, medical care, education, recreation, apparel, and other goods and services.

The CPI has several versions that exclude or include certain items based on their volatility or relevance. For example:

  • The CPI-U (CPI for all urban consumers) is the broadest measure of CPI that covers all items in the basket.
  • The CPI-W (CPI for urban wage earners and clerical workers) is a narrower measure of CPI that covers only the items purchased by workers who earn more than half of their income from clerical or wage occupations.
  • The CPI-E (CPI for the elderly) is an experimental measure of CPI that covers only the items purchased by households whose reference person or spouse is 62 years or older.
  • The core CPI is a measure of CPI that excludes food and energy, which are considered to be more volatile and less reflective of underlying inflation trends.
  • The chained CPI is a measure of CPI that uses a different formula to account for changes in consumer behaviour and substitution effects, which means that consumers tend to buy cheaper alternatives when prices rise.

Another common measure of inflation in the U.S. is the personal consumption expenditures (PCE) price index, which tracks the changes in prices of goods and services purchased by households, businesses, governments, and foreigners.

The PCE price index covers a broader range of goods and services than the CPI, and uses different weights and adjustments based on actual spending patterns and data sources.

The PCE price index also has several versions that exclude or include certain items based on their volatility or relevance. For example:

  • The headline PCE price index is the broadest measure of the PCE price index that covers all items in the basket.
  • The core PCE price index is a measure of the PCE price index that excludes food and energy, which are considered to be more volatile and less reflective of underlying inflation trends.
  • The market-based PCE price index is a measure of the PCE price index that excludes items that do not have observable market prices, such as imputed rents, financial services, and government-provided health care.

The Federal Reserve prefers to use the PCE price index over the CPI as its main measure of inflation for several reasons.

First, the PCE price index covers a wider range of goods and services than the CPI, which makes it more comprehensive and representative.

Second, the PCE price index uses different weights and adjustments based on actual spending patterns and data sources, which makes it more accurate and timely.

Third, the PCE price index tends to be less volatile and more stable than the CPI, which makes it easier to detect and analyze inflation trends.

How to Peel the Inflation Onion?

One way to understand inflation better is to peel the inflation onion and analyze its different layers. This means breaking down inflation into its various components based on their characteristics, such as their source, volatility, persistence, or importance.

The outer layer of the onion consists of prices of globally traded commodities, such as lumber, steel, grains, and oil. These prices are influenced by global supply and demand factors, such as production levels, weather conditions, geopolitical events, or exchange rates. These prices tend to be very volatile and unpredictable and can cause large swings in inflation over short periods of time.

The middle layer of the onion consists of prices of goods, such as appliances, furniture, and cars. These prices are influenced by domestic supply and demand factors, such as consumer preferences, income levels, interest rates, or supply chain disruptions. These prices tend to be less volatile but more persistent than commodity prices and can cause moderate changes in inflation over medium periods of time.

The centre layer of the onion consists of underlying inflation, which includes measures for shelter and other non-energy services. These prices are influenced by the overall balance between supply and demand in the economy and tend to change more slowly and steadily than commodity or goods prices. These prices are also more important for inflation, as they account for a larger share of consumer spending and reflect longer-term inflation expectations.

By peeling the inflation onion and looking at its different layers, we can gain a deeper insight into what drives inflation and how it evolves over time. We can also identify which components of inflation are more temporary or transitory, and which ones are more permanent or persistent. This can help us assess the current and future state of inflation and its implications for monetary policy and economic activity.

How to Use the Tools and Methods that Central Bankers Use to Measure and Monitor Inflation?

Central bankers use various tools and methods to measure and monitor inflation and its determinants. Some of these tools and methods are:

  • Inflation indicators: These are statistical measures that track the changes in prices of goods and services over time. Some examples are:
    • The CPI
    • The PCE price index
    • The GDP deflator
    • The producer price index (PPI)
    • The import price index (IPI)
    • The export price index (EPI)
  • Inflation expectations: These measures capture the beliefs or forecasts of consumers, businesses, investors, or economists about future inflation. Some examples are:
    • Surveys of consumer expectations (SCE)
    • Surveys of professional forecasters
  • Market-based measures: These are measures that capture the implied inflation expectations from financial markets, such as inflation-indexed bonds or inflation swaps. Some examples are:
    • The breakeven inflation rate (BEI)
    • The inflation swap rate
    • The inflation risk premium
  • Inflation models: These are mathematical models that describe the behavior of inflation based on economic theory and empirical data. Some examples are:
    • The Phillips curve
    • The New Keynesian model
    • The DSGE model
  • Inflation scenarios: These are hypothetical situations that illustrate the possible outcomes of inflation under different assumptions or conditions. Some examples are:
    • A demand shock scenario
    • A supply shock scenario
    • A policy shock scenario

By using these tools and methods, central bankers can gain a deeper understanding of inflation and its dynamics, and can make more informed and effective decisions about monetary policy.

How to Apply This Knowledge to Your Own Financial Situation?

Understanding inflation is not just an academic exercise. It has practical implications for your everyday life and financial decisions. Here are some ways you can apply this knowledge to your own financial situation:

  • Spending: If you expect inflation to rise, you might want to buy certain goods or services now before their prices go up. If you expect inflation to fall, you might want to delay your purchases until their prices go down.
  • Saving: If you expect inflation to rise, you might want to save more to preserve your purchasing power. If you expect inflation to fall, you might want to save less as your money will be worth more in the future.
  • Investing: If you expect inflation to rise, you might want to invest in assets that offer a higher return or that are protected against inflation, such as stocks, real estate, gold, or TIPS. If you expect inflation to fall, you might want to invest in assets that offer a lower return or that are sensitive to deflation, such as bonds, cash, or CDs.
  • Borrowing: If you expect inflation to rise, you might want to borrow now before interest rates go up. If you expect inflation to fall, you might want to borrow later when interest rates go down.
  • Planning: If you expect inflation to rise, you might want to plan for higher costs of living and lower standards of living. If you expect inflation to fall, you might want to plan for lower costs of living and higher standards of living.

By understanding and anticipating inflation, you can make smarter and more informed decisions about your spending, saving, investing, borrowing, and planning. You can also protect yourself against the risks and uncertainties of inflation.

Conclusion

Inflation is a complex and important topic that affects everyone’s life and finances. But with the right knowledge and tools, anyone can understand it like a pro.

Here are the 5 main points we covered in this blog post:

  1. What is Inflation? Inflation is the general increase in prices over time. It affects your purchasing power and standard of living.
  2. How is Inflation Measured? Inflation is measured by various indicators such as the CPI or PCE price index.
  3. How to Peel the Inflation Onion? By breaking down inflation into its various components based on their characteristics.
  4. How to Use the Tools and Methods that Central Bankers Use? Central bankers use various tools and methods such as inflation indicators, expectations, models, scenarios.
  5. How to Apply This Knowledge? By making informed decisions about your spending, saving, investing, borrowing based on your understanding of inflation.

Remember: Knowledge is power. The more you know about inflation, the better prepared you will be for whatever comes your way.

I hope this blog post has helped demystify the concept of inflation for you. If it has sparked your interest in economics or finance:

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

Thank you for reading! Please feel free to share this post with others who might find it useful or interesting.

P.S. What is one thing that surprised you or intrigued you about inflation? Let me know in the comment section.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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Reference

This blog post was inspired by the speech of John C. Williams, the President and Chief Executive Officer of the Federal Reserve Bank of New York, on September 29, 2023. The speech was titled “Peeling the Inflation Onion, Revisited”.

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