🔔 An idiot's guide to inflation: why is it important?

You've probably heard of inflation, but why is it REALLY important?

And why do people misunderstand inflation as well?

It seems like such a simple concept... but it can also make you feel like an idiot.

Once you get that inflation = prices going up, what more is there to know?

And why should anyone care about inflation anyway?

Well, inflation's a tricky thing. It can impact us all, and not just in the cost of the things we buy, but other subtle, less visible ways too.

I'm going to attempt to make inflation interesting, and make the case for caring about it.

An impossible dream? Perhaps, but let's go anyway...

What is inflation?

Broadly speaking, inflation is a measure of the average cost of living.

More specifically, inflation is how we track the changes in the average cost of living.

The Consumer Price Index (CPI) is the most widely-used measure & tracks the value of a basket of goods that 'most people' would consume.

There are plenty of flaws with the index and how it is calculated, so it's best to think of this the same way as we think of the BMI to measure obesity: Broadly accurate, yet imperfect.

CPI is then split into headline & core figures...

• Headline inflation includes the more volatile food & energy prices, and is a better example of real expenses.

• Core inflation ignores food & energy, so is thought to be a more accurate, stable indicator.

Now we know a bit more about how inflation is defined.

Let's bring in the other 'flations and then bring everything together at the end...

This Tweet was a great explainer:

Some people still got confused in the replies, so let's make it even clearer..

Inflation is the Rate Of Change of prices.

Prices are constantly changing.

To understand inflation there are two questions to ask:

1. Are prices going up or going down?

2. How fast are prices changing?

This is where we bring the 'flations in.

• Inflation = Prices increasing 📈

• Disinflation = Prices increasing 📈 (but slower)

• Deflation = Prices falling 📉

Examples of how inflation, disinflation and deflation work

A laptop 💻 costs $1,000 today (Month 0).

Next month (1) it costs $1,500... 📈 That's 50% inflation.

The following month (2) it costs $1,750 📈 That's disinflation.

Sounds wrong, doesn't it? It's a terrible name.

I mean... If it costs more it's still inflation... right?

DISinflation makes NO sense.

We should rename it Slowerflation...

Not the prettiest word, but more descriptive of what's actually happening.

Prices are still increasing, but at a slower rate than before.

Month 0 to Month 1: $1,000 to $1,500 is a 50% price hike...

Month 1 to Month 2: $1,500 to $1,750 is a 16.6% price hike...

the instinctive thing to do here is add these figures together and draw a conclusion that

50% + 16.6% = 66.6% inflation over the two months.

But that would be wrong...

It's all about the Rate Of Change across time.

Let's go back to those two questions.  

In the space of two months, we know the price of the laptop has gone from $1,000 to $1,750.

It's now 75% more expensive (not 66.6%) compared to month 0...

We've established that the price is going up.

That's question 1 answered (are prices going up or down?)

Onto question 2 (how fast are prices changing?)...

If we only know that the price has increased by 75% in two months, that second question is impossible to answer...

However, if we know the Month over Month (MoM) increase, we can measure that all-important rate of change...

Month 0 to Month 1: Price increased by 50%

Month 1 to Month 2: Price increased by 16.6%

So prices ARE changing, but not as quickly as they were before.

That's disinflation (slowerflation) explained.

Deflation is far simpler.  

The laptop 💻 costs $1,000 today.

Next month it costs $990... 📉

The following month it costs $980

Prices are going down. That's deflation.

That's it.

That's the nuts and bolts of inflation.

But...

Back in the real world, have you ever seen anyone walk around the supermarket checking whether things cost 2% more than last year?

I haven't (and if I did I'd keep my distance)...

It's just not something people in developed nations think about.

So, why else does inflation really matter?

• Inflation influences the price of debt.

• Most nations operate a debt-based monetary system.

• Debt is everywhere. Everyone is in debt or influenced by debt.

Debt is the foundation of modern society 👇👇

(Just don't ask who owes what to who, we'll be here a while)

When central banks preach about 'financial stability', this is what they mean.

It's the stability of the price of goods and services... and stability of the price of debt (interest rates).

The U.S. Federal Reserve explain why that stability matters (and why they aim for 2% annual inflation over the long run) 👇

Over the long-run is a key phrase and has been perfectly illustrated by these past two years.

Due to the pandemic, we have seen core inflation fluctuate between 1.2% & 3.8% since May 2019 👇👇👇

Average Core CPI inflation is 2% over the two year period.

As noted earlier, CPI is the most universal metric.

If we use the Fed's preferred measure (Core PCE), the figure is actually 1.6%.

If inflation persists above the 2% target, the Federal reserve will increase interest rates to dampen inflationary pressures.

Put another way, they re-establish the cost of debt.

The plan would be to do so in an orderly, sequenced manner so that financial stability can be maintained.

This is where the recent 'transitory' debate has centred.

Back to the laptop example.

💻 Laptop costs $1,000, increases by 3.8% (inflation). Laptop now costs $1038.

❗ The laptop does not need to return to $1,000 for this inflation to be transitory.

If it did, that would be deflation.

'Transitory' references a return to the inflation target (2%).

The following year, the laptop 'should' cost around $1059 ($1,038 + 2%).

The fear that inflation is NOT transitory is based on the monetary policy response.

The Federal Reserve could be forced to hike rates aggressively to 'get ahead' of inflation.

Why would this be undesirable?

Rapid increases in the cost of debt impact can influence how people make decisions (and how they spend).

For example, a household with a variable rate mortgage will suddenly see their monthly payments increase.

Take out a loan for a holiday or a new car, it suddenly costs a lot more.

People can suddenly feel poorer.

Remember, it's that rate of change that matters most.

The same goes for businesses and lending.

If debt becomes more expensive (or harder to access), business cash flows are impacted.

Lines of credit with suppliers may be reduced or removed altogether.

Suddenly, there's less cash on hand AND less access to credit.

"Maybe we should hold off on that hiring drive until things settle down..."

These behaviours can be contagious, so economic activity is more likely to slow if the cost of debt changes too quickly.

There you have it.

The idiot's guide to inflation.