What Americans should know about inflation as it hits a 30-year high

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Economists break down why consumer prices are so high right now.

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Americans across the country are seeing higher prices at malls, grocery stores and gas pumps, adding new pain to their pocketbooks, just as the holiday shopping season is about to begin.

Inflation has risen at the highest rate in three decades, with data released by the Labor Department earlier this week indicating consumer prices rose 6.2% compared to the same period last year. This is the biggest one-year jump the government’s consumer price index has seen since 1990.

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As inflation tightens its grip on the economy, the Federal Reserve has begun to withdraw past assurances that it will be a temporary, post-pandemic blow. Economists at Goldman Sachs warned in a research note last week that inflation is “likely to get worse before it gets better” and could continue well into the next year.

Many Americans are now young enough to remember inflation of the pain and uncertainty that swept the country in the 1970s, a period What economists dub as the “Great Inflation” When wages and prices snowballed and the purchasing power of savings dwindled before a painful recovery that led to the recession and double-digit unemployment rate of the early 1980s.

A generation later and under very different circumstances, prices are again rising rapidly. While economists say policymakers are now better equipped to respond to inflation in the U.S. than last time, consumers are already feeling the pressure – especially with limited means to higher prices for essentials. to absorb.

Here’s what Americans should know about inflation, why it’s so high right now, and when they can expect relief.

What is inflation?

“Basically, inflation measures the rate of increase in consumer prices,” Itte Goldstein, a professor of finance and economics at the University of Pennsylvania’s Wharton School of Business, told ABC News. “At the end of the day, it measures the extent to which the cost of living is high.”

Federal Reserve, America’s central banking system, defines Inflation as “the increase in the prices of goods and services over time”.

“Inflation cannot be measured by the increase in the cost of one product or service, or even multiple products or services,” the Fed said. “Rather, inflation is a general increase in the overall price level of goods and services in the economy.”

Policy makers evaluate changes in inflation by monitoring several different price indices. One of the most commonly used barometers of inflation is the Consumer Price Index, which is released each month by the Department of Labor and measures the average change over time in prices paid by consumers for a market basket of goods and services. Is.

According to DoL data, the CPI has increased by 6.2% since last October. Data from the DOL indicated that the so-called “core index”, or measure, for all commodities except the more volatile food and energy indices, rose 4.6% over the past 12 months. This is the biggest one-year increase since August 1991.

“Inflation means your dollar won’t go as far,” Laura Veldkamp, ​​a professor of finance at Columbia Business School, told ABC News. She used Christmas gifts as an example, saying that if you were to buy a sweater as a gift for $100 last year, that price might be closer to $105.

If the prices of some goods and services rise and the prices of others fall, but the aggregate prices paid by consumers for a bundle of goods and services do not increase, it is not referred to as inflation. Is.

What causes inflation, and why is it so high right now?

Inflation is determined by the interaction of aggregate demand (aggregate demand) and aggregate supply (aggregate supply) in the economy. If the total expenditure in the economy exceeds the total amount that the economy can produce, then output cannot increase but prices will rise.

“When your demand is high, the price goes up. When you have less supply, the price goes up too,” Goldstein told ABC News. “At the end of the day, price is a combination of these forces.”

But monetary policies also affect inflation, he said. According to Goldstein, keeping interest rates low and pouring a lot of money into financial markets — the actions the Fed took during the health crisis to help bounce the economy — can also be linked to higher inflation.

Stimulus checks boost aggregate demand, as well as the ability to supply goods and services that have been restricted by the pandemic. Goldstein said the impact of stimulus money on inflation is now waning, but there remain many other factors that create an imbalance between supply and demand.

“People think they have money to spend, they want to spend it on things they haven’t done in the last year,” Goldstein said. “You basically have a limit on supply at the same time you have an increase in demand, and that certainly drives up prices.”

Weldkamp also emphasized the impact of supply chain issues on pushing up prices. Using the Christmas sweater metaphor again, Veldkamp said, “Suppose Christmas sweaters are stuck on a boat somewhere, then some sweaters that are here, many people want them.”

“So, stores may charge more for them, because they are rare,” she explained.

The cost of doing business has also gone up during the pandemic, Veldkamp said, as companies have had to spend more to make it safe to do business while COVID-19 spread.

“Finally, workers are asking for higher wages,” Veldkamp said. “Which may be perfectly reasonable, but it makes the cost of doing business higher. Let’s say if a restaurant waitstaff wants a 5%, 10% increase, those restaurants will pass some of that extra cost to their customers.” have to pay, otherwise they will not make profit.”

An economic phenomenon known as a “wage-price spiral” can develop when prices rise and then workers demand higher wages – which can lead to further increases in the prices of goods and services. wages and so on. In this way, inflation can become a kind of self-fulfilling prophecy. This ever-increasing wage-price spiral characterized the US economy in the ’70s, eventually resulting in double-digit inflation.

How does an increase in inflation affect consumers?

If consumers’ wages increase with the rise in prices, they should be able to continue buying the same amount of goods and services as usual. However, this won’t be true for all consumers, which means some people may have difficulty buying what they used to.

“Your dollar doesn’t go that far, so it’s going to be a little harder to buy everything on your list with the same amount,” Veldkamp said. “And that sounds bad, but at the same time, wages are rising, and with inflation comes returns.”

Goldstein reiterated that the effect of inflation on consumers is that “when prices rise, people will have to pay more for whatever they want, and as a result, they can spend less.”

He also cited the wage-price spiral to show how inflation “can get out of control.”

“What can happen is that everyone has to pay more, so they go back and start demanding an increase in wages,” he said. “And if wages start to rise, the whole process can get additional amplification and like a snowball eventually becomes very hard to control – and then it becomes very difficult to bring things back.”

What is the effect of inflation on the stock market?

Stocks are a claim on firms’ future earnings, so in theory, firms should be able to raise their prices in line with inflation so as not to reduce their earnings.

Historically, however, inflation has been linked to negative effects on the stock market. One reason for this is that inflation restricts the ability of the Federal Reserve to act. After harsh policies defeated rising inflation in the US in the early 1980s, the Fed has been able to ease monetary policy following adverse events such as the stock market crash and the global financial crisis in 2008 and the COVID-19 pandemic. However, when inflation is rising, the Fed does not have as much freedom to implement expansionary monetary policy, and when the Fed contracts its expansionary policies, it can reduce stock prices.

Inflation is also often accompanied by uncertainty, which can be bad for the stock market. Investors do not know how long this will last and do not know what to expect from monetary policy, which means they may be less likely to invest in it.

Driven by the price hike, Weldkamp said that in the near term, investors will see higher returns on stocks in times of inflation.

Goldstein warns, however, that once inflation begins to rise, the Fed will have “no choice but to raise rates abruptly.”

“And when that happens, it will have a negative impact on the stock market,” he said.

What can the government do to reduce inflation?

According to Goldstein, the Federal Reserve will likely raise interest rates and ease pandemic-era expansionary monetary policies, which injected liquidity into financial markets, although he said it is a “tough balance” as the economy is still on a recovery. moving towards.

“On the one hand, you want to provide stimulus to the economy and the markets to recover from the crisis,” he said of the Fed. “But on the other hand, you don’t want to overdo it, so that things don’t overheat and cause inflation.”

Echoing Goldstein’s sentiments, Veldkamp told ABC News, “We’re probably going to see some interest rate hikes.”

“So, if someone hasn’t already refinanced their mortgage, now would be the time to do so,” she said. “We’ll probably see the Federal Reserve raising interest rates, because that’s their primary tool for reducing inflation, and what it does is encourage people to save their money.”

But Goldstein warns that “there isn’t much the government can do” when it comes to inflation.

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