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What Is Inflation?

Inflation is a decrease in purchasing power over time. In other words, it’s a rise in prices. With inflation, prices of goods and services rise as money becomes worth less.

While it’s not guaranteed, inflation typically happens consistently at roughly 2% per year. Over the years, these inflation percentages add up. While in one year a $1 bill may go down in value of about $0.02, over 50 years it may go down by $0.64.

There are certain situations where inflation may be negative (known as deflation), although with nearly 100 years of measuring purchasing power, inflation has continued onwards.

As prices rise and money’s value falls, the amount that a dollar can buy decreases. For example, up until 1959 you would have been able to buy a bottle Coca-Cola for $0.05. Alongside the United States’ increase in the amount of bills in circulation to pay for infrastructure, bills, and other expenses, prices across the country have increased.

How Does Inflation Work?

Inflation occurs when the United States' Federal Reserve increases the number of bills in circulation. It's essential to note that the actual amount of money doesn't increase, but there are more bills. When this happens, the value of the currency, like the US dollar, goes down, and each bill is worth less. To compensate for this decrease in value, companies, such as Coca-Cola in the earlier example, often raise their prices for products.

Examples

Let’s say the United States had $1 trillion in bills in circulation around the world. At this base value, a dollar is worth $1. If the government decided to print out $1 trillion more to cover expenses, then there would be $2 trillion bills in circulation. As there are more physical bills out in the world, but the value hasn’t increased, then a dollar would be worth half as much. In this extreme example, a dollar bill would be valued at $0.50.

Since a dollar can only buy $0.50 worth of a product now, then sellers might increase their prices to make up for the loss in value. With this dramatic scenario, a $1 item might be sold for $2 now, or it might slowly increase in price over time, to make up for inflation. This number is usually measured with a CPI or Consumer Price Index, which measures the relative price of something. If the $2 item originally cost $1, then the CPI would be 200, as it’s 200% the original price.

Is Inflation Good or Bad?

Whether inflation is considered good or bad depends on how much it increases. Most experts agree that too much or too little inflation is not ideal. When inflation is too high, the value of a dollar decreases, leading to rising prices, higher wages, reduced savings, and general dissatisfaction. On the other hand, if there's too little inflation, important projects might not get off the ground, demand for goods may drop, the economy can slow down, and wages could decrease. Finding the right balance is key to a healthy economy.

Disadvantages

There are, of course, some negatives. These might include:

  • Hoarding: to escape a drop in the value of a dollar, people buy commodities or goods.
  • Hyperinflation: if inflation speeds up too much, people won't purchase goods and services and the loop continues. In these scenarios, money can potentially become worthless.
  • Costs: as inflation increases, then prices do as well. This may be from increased material costs, product costs, labor, or anything in between.

Benefits

There are, of course, some negatives. These might include:

  • Additional options: with inflation, the Federal Reserve and US government can do more, changing rates, operations, and more.
  • Smaller debts: inflation allows debt to slowly decrease in value if rates are ignored, meaning that those in debt can pay it off for less.
  • Better than deflation: deflation can result in many issues, potentially running economies off track. Inflation, while not perfect, is much better than the alternative.

The US government has pushed a target of 2% inflation annually, which works to help boost the economy over time. This also helps reduce the size of debts, doesn’t harm savings too much, helps to increase demand for products, and allows the government to undertake large projects. It all depends on context though, as some periods of low or high inflation may need high or low inflation, respectively, to follow up.

What’s the United States’ History with Inflation?

The US is an odd case when it comes to inflation. Over 88% of foreign trades use the US dollar, and it’s the world’s primary reserve currency. Thousands of banks and billions of people across the world either use or store USD (United States dollar), so the United States government must be especially careful about inflation.

Average Inflation

Luckily though, the Feds have been careful with the dollar’s inflation, keeping just an average inflation rate of around 3.1%. This means, over the last 25 years, prices have increased around 115%. While that may seem like a lot, it pales in comparison to similarly-sized Brazil’s annual inflation of 328%.

High Highs and Low Lows

With the dollar’s low inflation rate, it helps to ensure that the USD remains a useful currency across the world. Even still, there have been some years with above average inflation, usually following an accident or a crisis. Including the 2020 Coronavirus pandemic, these years have the United States government printing money to afford large relief packages or infrastructure projects.

Some of these years include:

  • 1916 - 1920 | between 7.64% and 17.8% | World War I
  • 1942 | 10.97% | World War II
  • 1947 | 14.65% | Marshall Plan
  • 1974 – 1981 | between 5.75% and 13.58% | Nixon Untying Gold from USD
  • 2021 | up to 5% so far | Coronavirus Pandemic

In many of these scenarios, the Federal Reserve will move to increase interest rates, which slows down the economy. As increasing inflation increases the economy, by slowing down the economy, inflation falls. In scenarios with a fall in spending, the States decrease interest rates to attempt to boost inflation and spending. When rates rise, inflation falls.

With the Coronavirus pandemic, inflation had fallen to great lows as the government dropped interest rates and spending stopped. The number has increased since then, reaching a 13-year high earlier in 2021, thanks in part to the multi-trillion-dollar stimulus packages.

As these are massive, the Federal Reserve increases the amount of bills in circulation to pay for it. Inflation then increased as the number of bills and value of money attempted to even themselves out.

Since its founding, the United States Federal Reserve has slowly decreased inflation rates over time. Even still, there are countless spikes and dips as different things occurred. The highest inflation rate since the United States’ beginning was 29.78% in 1778, although the highest rate since the Consumer Price Index’s (CPI) creation was 19.66% in 1917. Following these two, the Reserve went through periods of deflation, as negative inflation was the only option at the time.

Inflation Per Decade

The Federal Reserve didn’t have a plan as to what the consensus inflation rate was to be, so for the first few decades since the CPI’s creation in 1913, inflation was all over the place. With the addition of World War I and WWII, the Great Depression and more, there were many major events.

Why Is It Important to Understand Inflation?

Inflation is an always changing and always present part of living in the United States or using the USD. With a government as big as in the States, there will always be major expenses which will have to be paid with printed money. There’s also the constant need to stimulate the economy and its growth, especially with over 300 million citizens within the nation.

There will always be years with high inflation alongside low inflation. Following the Coronavirus pandemic, inflation immediately sped up, but understanding inflation allows you to prevent losing money. Inflation also erodes at your wealth overtime, meaning that putting up a shield against inflation can be exceedingly important.

Saving Your Future

By understanding that inflation will continue, you can act and prevent yourself from falling victim to its associated issues. You can also take advantage of certain aspects, including falling debt values or increasing wages. To beat the 3% annual inflation which is nearing 2%, invest your wealth in high income savings accounts or the stock market. A high percentage over 2% or investing in the S&P 500 will almost guarantee you can outdo the negative effects of inflation.

The most important reason behind understanding inflation, is preventing yourself from acting irrationally. While inflation speeds up on occasion, many people move their money to non-consumables or stop themselves from spending. By understanding that inflation is usually compensated with buybacks or lower interest rates, you can help prevent yourself from moving too quickly.

2024 and Beyond

In the second half of 2023, the economy grows slowly, only by 0.4 percent per year. When we look at the entire year, the economy only goes up by 0.9 percent. However, things get better after 2023 because the government makes it easier for businesses to borrow money. In 2024, the economy grows by 1.5 percent, and in 2025, it grows even faster, by 2.4 percent.

The unemployment rate goes up to 4.1 percent by the end of 2023 and then increases to 4.7 percent by the end of 2024. However, it improves a bit in 2025, dropping to 4.5 percent. In 2024, we see a decrease of about 10,000 jobs per month on average, but in 2025, there's an improvement with an average increase of 6,000 jobs per month.

The rate at which prices for things people buy (called the "price index for personal consumption expenditures" or PCE) is going to slow down. It's expected to go from 3.3 percent in 2023 to 2.6 percent in 2024 and then down to 2.2 percent in 2025. This slowdown happens for a few reasons. One is that the job market isn't doing as well, and another is that home prices are not growing as fast (in some places, they are even going down), and this affects the cost of renting homes.

The Federal Reserve, which manages our country's money, raises the interest rate it controls (called the federal funds rate) in the middle of 2023. However, in the first half of 2024, they start to lower this interest rate because inflation is slowing down. The interest rate goes down from 5.4 percent at the end of 2023 to 4.5 percent by the end of 2024, and it's expected to be at 3.6 percent by the end of 2025.

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