Inflation is the rise in prices of goods and services which overtime will erode the purchasing power of money. With inflation, a dollar buys less and less over time. Historically, inflation has a significant and extremely unpredictable influence on interest rate levels. If prices increase, more money will be needed to buy the same items. Inflation risk is the type of risk you face when you put your money in a low interest savings account. In general, ownership types of investments move ahead with inflation, at least when inflation is not too high, while holders of fixed return lending alternatives may suffer from inflation. The risk of losing purchasing power through increased inflation leads to an inflation premium component found in interest rates. The inflation premium component of interest rates is intended to preserve the purchasing power of the investor over time.
The inflation premium in interest rates is intended to compensate for inflation reflects the expectations of the future inflation level over the lifespan of an investment. This occurs because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future. The greater the expectations for future inflation will lead to an elevated inflation premium and higher interest rates today. Inflation expectations are based heavily on recent inflation. So, rates generally are high when inflation is rapid. Conversely, expectations of lower levels of future inflation result in a lower interest rates today.
Some degree of inflation will always be priced into interest rates. It is not fundamentally a bad event but it impacts the rate of return that depositors will receive and consumers need to understand the impacts of inflation on all interest rate sensitive assets.
The general rule governing the time value of money is based on the assumption that an depositor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future without compensation for the loss of value via decreased purchasing power.
The inflation premium factor of interest rates exists because the lender, whether it is a bank making a consumer loan or a depositor making loan to a bank by opening a long term certificate of deposit, is deferring his consumption. The interest received is payment for this service but the lender will want to make sure they will recover enough interest to pay the increased cost of goods due to inflation.
The best economists of the world have studied the causes of inflation for quite some time. Unfortunately, there is little consensus on the exact forces that drive inflation nor is there a common formula for forecasting future inflation levels. Three theories that are commonly acknowledged on the causation of inflation are, demand-pull inflation, cost-push inflation and inflation caused by unrestrained production in the money supply.
Demand-pull inflation can be summarized by the representation of having too much money chasing too few goods. Too much money in this situation refers to demand in the economy growing faster than the supply of goods and services. The result of excess demand and limited supply is an increase in prices. This form of inflation usually occurs in rapidly growing economies.
Demand-pull inflation occurs when aggregate demand for goods and services in an economy is expanding faster than the rate of production in goods and services. In the short run, businesses cannot significantly increase production and supply remains constant. The economy’s equilibrium moves to a point of excess demand and limited supply with the outcome of rising prices. As prices tend to rise in this condition, inflation ensues.
Cost-push inflation arises when prices in the production process increases. Rapid wage increases or rising raw material prices are familiar causes of this type of inflation. When companies’ costs go up, they need to increase prices to maintain their profits. The increased cost of their wages or supply of goods leads to increases in the finished goods or services to consumers and an escalation of consumer price levels. Increased costs for producers may include higher wages, significant increases in taxes, or added costs of raw materials.
Inflation created by excess money supply is the result of a central bank that rapidly increases the supply of money greater than an economy’s productive capacity. If the supply of money and credit increases too rapidly over many months, the result will be inflation. Simply stated, too much money in the economy can lead to inflation, while too little can stifle economic growth.
The increase in money in the economy is closely monitored and to some extent, controlled by central bankers. The Federal Reserve tries to maintain a course of action that routinely checks to ensure that the supply of money within the economy is neither too large which may cause prices to increase nor too small which may cause prices to decrease.
Sustained levels of high inflation can have a very unfavorable on the economy and the value of assets. Inflation might make people worse off if their incomes don’t rise as rapidly as prices. Lenders might lose because they will be repaid with dollars that aren’t worth as much. Savers might lose because the dollar they save today will not buy as much when they are ready to spend it. Businesses will find it harder to plan and therefore may decrease investment in future projects. Owners of financial assets suffer.
Inflation can often result in the deterrence of economic growth. In production, it makes it harder to tell what a change in the price of a particular product means. For example, a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices. When inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds that highly variable inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.
The Federal Reserve carefully reviews and analyzes the available inflation measures to monitor how well it is achieving its price stability goal. One common way economists use inflation data is by looking at “core inflation,” which is generally defined as a chosen measure of inflation, the Consumer Price Index less prices for food and energy, the Personal Consumption Expenditures Price Index, or the Gross Domestic Product Deflator. The Fed is always viewing the long term and watches for inflation as a sustained increase in the general level of prices.
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