The Independent Market Observer

1/9/13 – Inflation Part 1: What Does It Mean and Should We Be Worrying Now?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 9, 2013 10:16:14 AM

and tagged Economics Lessons

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One question that has come up repeatedly when I talk with advisors and clients is whether inflation is coming. The answer is simple, if perhaps unexpected: hopefully, it is. What? Why on earth would we want inflation?

In fact, the Federal Reserve (the Fed) has been systematically trying to create inflation for the past couple years. It recently made that explicit by deciding to publicly focus on the other part of its mandate, employment, rather than on inflation. This is a huge change, as the Fed has been—and, just as important, has been perceived as being—all about anti-inflation. Why the change?

First, let’s define inflation as, for the purpose of this discussion, an increase in the price of things—houses, gasoline, cars, gold, or anything at all. This means that a dollar can buy less of any given thing every year because inflation results in higher prices in dollar terms for the same amount of any actual good. In other words: things cost more.

There are two main reasons why this happens. The first reason is the scarcity of the good. For example, during the oil embargo of the 1970s, there simply was not enough gasoline to go around, so prices got bid up. We recently saw this in the housing market, where house prices were bid up because more people wanted to buy houses than there were houses on the market.

The second reason is a bit more subtle. Just as a shortage in the supply of a particular good can drive the price of the good up, an excess supply of dollars can also drive the price up. In other words, if everyone has more dollars and the supply of the good in question—say, for example, houses—remains constant, people will be willing to pay more in dollars for that same good.

One way to think of this is to consider that, if people are willing to pay a certain percentage of the dollars they have, they will pay more in dollars if they have more dollars. Again, we saw this in the housing boom, where, with easy financing available, buyers effectively had access to more dollars and could and would pay more.

In the short run, inflation actually can be perceived as a good thing. For many people, inflated house values were considered to be real wealth. Because debt remains the same, even as values rise, wealth is apparently created from nothing. Who wouldn’t like that?

Because of this, a low level of inflation is generally considered acceptable. The Fed has an informal target of from 1 percent to 2 percent per year, which is large enough to provide some flexibility in pricing but not large enough to create problems. We have had exactly that range over the past couple decades in consumer prices, excluding housing, and the economy has seemed to benefit. That all changed with the financial crisis.

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