Inflation: Overview

Introduction

Inflation is defined as the increase in the price of goods and services over time. While some small-and-steady amount of inflation is normal, a significant increase in the inflation rate can lead to serious economic trouble. The problem with inflation is that it reduces purchasing power; if an individual or business is making the same amount of money as before and goods now cost more, that individual or business is getting a lot less for the money. This is why people often speak of receiving annual raises at work to “keep up with inflation.” Healthy companies generally provide their workers with an annual pay raise that corresponds to the inflation rate so that employees can maintain the same purchasing power, even if the price of goods goes up. During normal economic times, the inflation rate is usually small and consistent, but sometimes circumstances arise to artificially inflate or even deflate prices, such as a sudden increase or decrease in the availability of cash or credit.

Inflation is influenced by many factors and forces, and economists and policymakers have long debated the best ways to manage it. The issue gained increased attention throughout much of the world in the early 2020s, as inflation rates rose sharply following the severe economic disruption caused by crises such as the COVID-19 pandemic. Some observers called for strong governmental measures to reign in inflation, such as interest rate increases and monetary policy changes. However, others cautioned that many inflationary pressures were outside the government’s control and that some counterefforts might actually be more harmful to the economy in the long run.

Understanding the Discussion

Consumer Price Index (CPI): A numerical value established by the US Bureau of Labor Statistics that which expresses how much the cost of consumer goods has risen over time. The CPI is determined based on a hypothetical basket of commonly used goods; when the index was created, the value of the goods in this basket was $100. The CPI value is the same number as the dollar value of the goods.

Deflation: The result of the inflation rate being negative instead of positive, which means that the price of goods is decreasing rather than increasing.

Federal Reserve: The central bank of the United States, responsible for managing the nation’s supply of money and credit. The Federal Reserve also acts as banker for the US Department of Treasury, regulates much of the US financial and banking industry, and administers related consumer-protection laws.

Inflation: The increase in the price of goods over time.

Inflation rate: The amount by which prices are increasing, expressed as a percentage per year.

Purchasing power: The amount of goods a person can buy for a particular dollar amount.

History

As an economic phenomenon, inflation has existed since the development of currency in the ancient world. However, the modern understanding of the concept emerged in the nineteenth century. While at first the term was mainly associated with the devaluation of currency (monetary inflation), it later became most used to refer to increasing costs of goods.

Historically, inflation rates have tended to be relatively steady in most countries, including the United States. A small, steady rate of inflation is a sign of a growing economy, in which costs increase at a consistent rate each year. Salaries can usually keep pace with this type of inflation, because growing businesses can provide their employees with the raises necessary to maintain their purchasing power. However, there have also been historical periods of notably high or low inflation. In the United States, the establishment of the Federal Reserve as the nation's central bank in 1913 marks the beginning of careful and consistent tracking of economic data, and there have since been several episodes of significant inflation changes that have led to difficult economic times.

One of the most notable periods of rapid inflation took place in the lead-up to what is now known as the Great Depression. Double-digit inflation rates began in late 1916 and continued through the end of 1920. One of the primary reasons for this inflation was the United States’ entry into World War I, which had been raging in Europe for several years already. To finance the materials needed to enter the war, the United States found a roundabout way of essentially creating more money, rather than resorting to increasing taxes or government debt. By issuing war bonds, the government was able to create the money it needed to finance the war. However, adding more money to the economy has the effect of making that money worth less in the long run, and this created a significant period of inflation.

Beginning in early 1921, the inflation rate was actually negative, signaling a period of deflation, and remained that way until early 1923. In a deflation, the value of goods actually decreases, and since this hurts businesses, deflation is often accompanied by an increase in unemployment. Some possible explanations for this deflation include the rapid increase in the number of available workers caused by soldiers returning from war, the end of gold-backed currency, and a period of adjustment for the still relatively new Federal Reserve. In 1933, the Roosevelt Administration changed the basic valuation of the US dollar from the gold standard to the silver standard. This was done in an attempt to regenerate the domestic value of the dollar during the Great Depression. Historically, the use of silver as the basis of valuation had occurred for centuries. In the late nineteenth century, an era characterized by rising global trade and banking, gold became the basic means of valuation for industrialized nations. The US government's actions in 1933 were an example of a means of temporarily revaluating US currency during an economic crisis. To assist in the application of these economic reforms for valuation of currency, the authority of the US Federal Reserve System was expanded. In addition, macroeconomic policies of John Maynard Keynes added additional government involvement in the American free market system. The British, as well as numerous other governments, utilized similar practices to strengthen their respective currencies. The United States continued to experience low inflation, and even periods of significant deflation, until it became involved in World War II in the early 1940s. The inflation and deflation rates swung quite a bit during the war years before finally leveling out once World War II ended.

The United States also experienced significant swings between inflation and deflation from late 1973 until around 1983. This is thought to have been caused by a variety of factors, including supply-chain disruptions for certain goods such as food and oil. Periods of deflation may have been caused by increased unemployment due to a surge in available workers, as troops returning from the Vietnam War were seeking jobs at the same time that many women were entering the workforce for the first time. As a result of this instability, the Federal Reserve Act was amended in 1977 to give the Federal Reserve the power to establish policies that would minimize unemployment while keeping inflation in check. However, even once this amendment took effect, it was still several more years before inflation rates were again brought under control.

The Reagan Administration introduced a monetary policy that used interest rates as a means of regulating the flow of currency and curbing the debt in the economy. The administration also initiated tax cuts to introduce currency into the markets to help increase consumption. This reduction in tax revenue also accompanied attempts to cut government spending so that the government did not operate at a deficit. While these efforts to reduce spending were limited to cuts in social welfare programs, military spending increased. Inflation seemed to slow, but the government's growing debt from its continued practice of deficit spending posed a continued threat for the reintroduction of high inflation. When oil prices experienced a sudden drop in 1987, nearly a decade of inflationary relief followed.

The 1990s saw the beginning of a long period of relatively low and stable inflation in the United States. For the next three decades the inflation rate typically ranged from about 1 to 3 percent. (One notable exception came in 2009, when the rate was slightly deflated—that is, negative—following the 2008 financial crisis.) This stability set the tone for how many economists viewed inflation's overall role in the economic picture.

Inflation Today

A steady increase in the cost of goods is generally expected, as it is a sign of a growing economy. However, it is considered important to keep the inflation rate in check in order to balance the dueling problems of high prices and high unemployment. If inflation rates become too high, consumers lose purchasing power and could be in a position where they are unable to buy the things they need with the money they have. Conversely, if inflation is too low or if there is a period of deflation, unemployment tends to rise as businesses tighten their belts and reduce spending.

This cause-and-effect mechanism is how the Federal Reserve can influence inflation. The Federal Reserve is responsible for creating policies regarding the issuance of currency and credit, and thus it can control the flow of money into the US economy. This is important because if the amount of available money and credit increases too rapidly, businesses may not be able to keep up with demands of increased spending, which can cause the price of goods to rise, leading to inflation. Conversely, restricting the availability of money and credit can cause spending, and thus business activity, to decline, resulting in deflation. The 1977 amendment to the Federal Reserve Act established that the Federal Reserve must aim to minimize unemployment while stabilizing prices, and thus it must constantly seek to balance these interests.

An additional cause of inflation is an increase in government spending. When the federal government increases its spending, it has only a few choices for how to finance that spending: raise taxes, create more government debt, or print more money. Since raising taxes and adding to the national debt are politically unpopular choices, the government will often choose to print more money instead. However, this choice generally leads to inflation.

The need to maintain a delicate balance between employment and inflation is at the heart of the debate over how much independence the Federal Reserve should be granted from the federal government. As a result of the economic downturn that began in 2008, during which many significant institutions within the banking industry collapsed, many people questioned whether the Federal Reserve was up to the task of regulating the industry without oversight. On one hand, additional oversight would ensure that the chair and governors in charge of the Federal Reserve were accountable to someone other than themselves. Regular audits by another government branch would encourage them to consider as much relevant information as possible before making a decision, effectively requiring that the Federal Reserve provide a thorough justification for its policies.

However, many economists expressed concern that giving elected officials the power to influence Federal Reserve policies could result in decisions being made to promote short-term gain rather than a positive long-term outcome. For example, a politician seeking reelection could influence the policies of the Federal Reserve to push a significant amount of currency and credit into the economy in the six to twelve months leading up to an election. While this might decrease unemployment and increase consumer spending in the short term, it is likely to lead to difficult-to-solve inflation problems in the long term.

Debate over inflation increased in the early 2020s as the decades of relative stability ended and the inflation rate in the US increased sharply. In 2021 economists began to warn that inflation was increasing at faster rates than seen since the early 1980s. Initially, many suggested price increases were largely due to supply chain disruptions amid the ongoing coronavirus disease 2019 (COVID-19) pandemic. However, other indicators soon revealed broader and stronger trends. By early 2022 continued strong inflation generated increasing public attention and concern, and rising CPI inflation reports indicated that inflation had not yet peaked in the US. Many news outlets began to cover inflation as a serious issue impacting American families as shelter, food, and fuel costs rose. Inflation, and potential ways to address it, also became a major political talking point. Although some economists continued to suggest the trend would eventually correct, the inflation rate in May 2022 again showed a steep increase, at 8.6 percent, followed by a rise to 9.1 percent in June—its highest level since 1981.

Several global factors were considered important in the rising inflation seen in the US and elsewhere. Though many economic sectors had largely rebounded from the impact of COVID-19, the ongoing pandemic and supply chain issues continued to influence costs in some industries. Interest rates had also remained relatively low since the 2008 global financial crisis. Various geopolitical dynamics also played a role, perhaps most notably Russia's invasion of Ukraine in February 2022. That war was especially linked to rising gas and oil prices, as many Western nations instated sanctions against Russia or even banned fuel imports from the country.

In an effort to control inflation, central banks in the US and other nations began to implement substantial interest rate increases. By August 2022, the US Federal Reserve had already raised interest rates four times that year, and experts hoped the rate hikes would prevent the nation, and potentially the world, from heading into an economic recession. That same month, the US Congress passed the Inflation Reduction Act of 2022 and President Joe Biden signed it into immediate effect. A wide-ranging budget reconciliation bill, the law included numerous policies that proponents suggested would help stabilize the economy, including substantial investment in domestic energy and climate change mitigation initiatives, efforts to lower prescription drug costs, and increased funding for the Internal Revenue Service for better tax enforcement. The Inflation Reduction Act proved controversial, however. It was opposed by all Republicans in Congress as government overspending, and while Democrats voted in favor, some progressives suggested it did not do enough to help working-class Americans. And while debate over the law was highly charged along partisan political lines, economists were also mixed in their appraisals of how effective the bill would be in actually reducing inflation, particularly in the short term.

By August 2023, one year after the Inflation Reduction Act was passed, the inflation rate had declined considerably, to about 3.2 percent. Most economists, however, agreed that the Inflation Reduction Act played little to no role in this trend (and even President Biden and other supporters of the law acknowledged that it was aimed at longer-term economic issues). Instead, experts suggested that interest rate increases, falling oil and gas prices, and further resolution of lingering supply-chain problems were the primary drivers of inflation relief. Even with the inflation rate returning to near-normal levels, though, price increases remained a major political issue. Many observers argued that the rate alone did not indicate the full burden on average Americans, as wage increases still lagged inflation and other pressures such as housing costs remained high. These economic issues were widely seen as contributing to the reelection of Republican president Donald Trump in 2024, as many voters held Biden and other Democrats to blame for the impact of inflation. Economists continued to debate the proper government response to inflation and its complex interactions with other socioeconomic forces.

These essays and any opinions, information or representations contained therein are the creation of the particular author and do not necessarily reflect the opinion of EBSCO Information Services.

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