What is Inflation and How Can Consumers Prepare?

When prices increase faster than families’ take home pay, household budgets have to stretch further. Dr. Zuzana Buzzell, associate dean of business, explains what exactly inflation is and how it occurs, and offers tips for consumers to cope with rising prices.

When economists and others talk about inflation, what exactly does that mean? What is inflation in laymen’s terms?

Inflation is the increase in prices of goods and services over a specific period of time. Generally it is measured and reported on quarterly or yearly basis. The price increases differ based on the specific goods or services as we have seen over the past year. For example, we have seen the prices of gas and used cars skyrocket, yet restaurant services stayed relatively low.

If salaries are not rising sufficiently to cover the sharp increase in prices for goods and services, your salary doesn’t go as far because almost everything is more expensive than before. In the U.S., salaries rise on average by 3% a year, according to the Society for Human Resource Management, while the current U.S. inflation rate is 7%, according to the Federal Reserve Bank of New York. The rise in salary does not cover the rise in prices.

When is inflation bad for the economy – or is it always a bad thing?

As with any economic indicator, there are positive and negative impacts. Let’s begin with some examples of the positives:

1. Economies need inflation. Steady year-to-year prices increases are needed in healthy markets. Companies have incentives to invest in research and development, new plants, new equipment to keep up with the demand and benefit from the higher revenue on their products.
2. High inflation benefits households with higher wages as they are able to pay off their debts faster as the income is rising faster and the interest rates on their debt remains the same.
3. If there is no inflation and prices stay at the same level, or go down, also known as deflation, that would be an issue. The consumer will hold off on purchases in hopes the prices will continue to fall. Companies would be hesitant to invest in new products, plants, equipment, etc. There would be no reward for the additional investments into their businesses.

Now let’s move on to the negative impact examples:

1. When wage increase don’t keep up with increases in consumer pricing on essential goods, such as gasoline and food, these items may become unaffordable for some.
2. Goods are increasing in price faster as production is more expensive due to higher costs for raw materials and production. The majority of the goods in our market are distributed using trucks. The increase in transportation cost is passed down to the consumer in the form of a price increase.
3. If there is an expectation that prices will continue to rise for an extended period of time, it might prompt consumers to spend money fast on durable goods and services in order to retain as much value as possible. This in turn would fuel more inflation and reduce the real value of every dollar earned and lead to hyperinflation – extremely high inflation.

There has been a lot of media coverage about inflation in the U.S. recently. How would you summarize the inflation ‘situation’ in the country right now?

The United States is not the only economy grappling with high inflation. Unfortunately, the sharp increase in inflation between 2019 and 2021 put the U.S. in the third-highest change out of 46 economically significant countries tracked by the Organization for Economic Cooperation and Development (OECD). The consumer prices hit an all-time 31-year high in October 2021, according to the Pew Research Center.

This has a significant impact on many aspects of the economy. The government and Federal Reserve should act quickly to address the rise. There needs to be a tightening on monetary policies, starting with the rise in interest rates and tapering the asset purchases.

The monetary policy needs to put more weight on inflation risks in 2022. This is particularly important as commodity prices are expected to rise again in 2022.

What are some of the ways that consumer are impacted by inflation?

In this case we will first look at the consumers who benefit from inflation:

1. Consumers holding debt with fixed rates are the big winners when it comes to inflation. The liabilities they took on are decreased by the inflation. In other words, the debt they took on is being paid off with a weaker dollar. The major loans we see in this category are 30-year mortgages with fixed rates and federal student loans.
2. Asset owners including consumers owning real estate and land as they do not depreciate as fast as savings.
3. Investors holding gold and silver as they are not subject to the same inflationary pressures.
4. Companies with fixed wages. These might be wages negotiated with large unions that change at a set time. Companies can temporarily benefit from the inability of the large unions to act fast and renegotiate salaries.

Now, let’s take a look at who has been negatively impacted by inflation:

1. Savers. During inflation, the prices rise and the real value of money falls. People will see their savings depleted faster as the higher prices decrease what we can purchase for the saved money.
2. Borrowers with variable rates. As the Federal Reserve reacts to inflation they might increase the interest rates, and this will impact all variable rates. Also, lenders would react to inflationary pressures and increase the interest rates to recoup the inflation losses.
3. Workers on fixed incomes as their income does not keep up with the price increases.

Inflation creates a shift in wealth. During regular inflationary years, the lenders and the savers were people with wealth and the borrowers were people without wealth. Inflation created an unfair situation where lenders and savers are on the losing end and borrowers with fixed-debt benefit from the weaker dollar.

What are some steps consumers can take to limit the impact inflation has on them and their families?

This is time to revisit the family budget. Don’t have one yet? Start one. It is as simple as opening an Excel and writing down monthly expenses and incomes. Remember that budgeting is one of the most important steps toward financial security.

As prices on necessities such as food and gas increase, families need to economize on other items. The 2021 food-at-home CPI (Consumer Price Index) increased by 6.5%, according to the U.S. Department of Agriculture, and families could see this reflected in their weekly grocery bill. Set priorities. Families can’t live without food; they need gas to go to work to earn money, so where in the monthly budget is an extra to make up for the higher prices?

Start with monthly and yearly subscriptions. Look at the recurring bills, and revisit every charge and ask the same question: Do we need this service? For example, do you watch shows on five different streaming services? If not, cancel it.

Next, look at all credit cards. Consolidate any balances to fixed, lower interest rates. Remember, debtors with low, fixed rates benefit from inflation. However, don’t accrue more debt.

Grocery bills are where planning ahead truly pays off. Sit down as a family and create a meal plan. Make it fun by allowing each member to pick their favorite meal and maybe help with the preparation later. Shop using a list and stick to it. Families can also plan meals based on the weekly discount flyers. If you have a hard time sticking to the grocery bill budget, shop with cash.

There are some costs that a family will not be able to decrease, such as monthly utility bills. These costs are also rising. Small changes such as waiting when you can run a full load in the washer might help, but as we use our homes as offices, utility bills have increased.