It seems as though the word inflation is used in almost every newscast or serious conversation about our national economy these days. However, inflation is one of those economic terms that is often misused and misunderstood. So, what is inflation and how does it impact personal finances?
Inflation means that the average of all prices in the economy is increasing. It does not mean that all prices are increasing, only the average of those prices. Even during periods of high inflation, some prices may actually be dropping while others are escalating rapidly.
It can be difficult for policymakers to react to changes in the inflation rate as they are working with this average of prices. Additionally, this average is not based on every product but rather a set market basket of products that are monitored regularly for price changes.
And to make it more confusing? There is more than one measure (or index) that measures inflation.
Most inflation reports are based on the official Consumer Price Index (CPI-U), a measure of price changes for a market basket of goods and services purchased by urban consumers, and is frequently called a cost-of-living index. This rate is generally reported monthly, quarterly and annually by Bureau of Labor Statistics, a division of the U.S. Department of Labor. Contents of the market basket for the CPI-U are intended to represent purchases made by “typical” U.S. families, divided into categories that include food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other. Each of these areas is weighted to reflect the typical percentage of household income allotted for those expenditures. While few families fit the actual model, it still allows government officials to determine what is happening to the prices of products commonly used by most households.
The core inflation rate is a rate that has been frequently quoted for the last several months. The core rate is based on the CPI-U without the products that tend to have highly volatile prices, such as gasoline and food. Energy and food prices tend to react much more quickly to what economists call “price shocks,” meaning that their availability can change rapidly and thus the cost to the consumer also changes rapidly. While these price shocks can certainly wreak havoc to a family’s spending plan, those changes may be short-lived. Using the core inflation rate—the CPI-U minus energy and food costs—to set policy gives decision makers a better look at long-term trends in prices. Therefore, it tends to be one of the most important indexes used to monitor the need for policy changes to offset the impact of inflation.
The CPI-U is important because it becomes the basis for changes in Social Security benefits and other cost-of-living adjustments tied to the inflation rate. Social Security recipients will receive an increase in their monthly payments when the CPI-U posts an increase at the end of the federal government’s fiscal year. Basically, this means that if the CPI-U for the year ending September 30 is higher than it was at that same time the previous year, recipients will receive an increase for the coming year. So, if the CPI-U for the year ending September 30, 2011, is four percent, then the government will announce that all Social Security checks will increase by four percent in January 2012 and continue at that amount until another increase is warranted.
The CPI-U also plays a role in setting the tax brackets for personal income tax. Tax brackets are used to set the maximum tax values for various income levels. Those brackets are adjusted annually based on the CPI-U. A higher rate of inflation will broaden those brackets to help families offset the increased purchasing prices for goods and services.
In addition, the inflation rate is a driving factor in setting interest rates; which means it has a big impact on mortgage rates, savings accounts, investment accounts, stock prices and a variety of other things that impact wealth and purchasing power. Lenders and investors often attempt to hedge against inflation, hoping to protect themselves from potential fluctuations in prices.
Measuring inflation and evaluating its economic impact is not a perfect science. It impacts people differently, depending upon a variety of situations. As a general rule, expected inflation is much easier to deal with than unexpected inflation—which generally results from price shocks.
While inflation sounds awful, deflation can be just as devastating to personal finances. Deflation means that goods and services, such as your home, are worth less today than what you paid for them. Therefore, most economists and policymakers are content to live with minimal rates of inflation.
Unfortunately, price changes are just a fact we have to live with in a market-based economy. Only in rare situations can we control what happens to price fluctuations; however, all families can develop an awareness of inflation trends and take steps to minimize the impact.
Ten Tips to Survive Inflation
1. Reevaluate budgets or spending plans to trim unnecessary spending.
2. Compare prices online, in advertisements and by phone to find the best deals.
3. Shop only when necessary and use a carefully planned list; buy “in season” or less expensive products when possible.
4. Cut costs by using carpools, finding less expensive entertainment options, eating at home more often, and controlling food expenses at the grocery store.
5. Look for ways to increase income, such as a second job, working extra hours or garage sales.
6. Avoid dipping into emergency savings or retirement accounts.
7. Avoid using credit cards or incurring additional debt.
8. Shop sales, discount stores and thrift stores.
9. Delay major purchases until absolutely necessary.
10. Realize it’s okay to say “no” to unplanned purchases not listed in the family budget.
Sue Lynn Sasser, PhD, is a Professor of Economics at the University of Central Oklahoma.