Consumer Price Inflation is when the prices of goods and services increase throughout the economy. When the money supply grows faster than the production of goods and services, there is more money chasing the same number of goods and services. Due to supply and demand, this bids up the prices of goods and services.
Another way of thinking of consumer price inflation is as a loss of purchasing power. When the money supply increases, the purchasing power of each unit of money decreases.
The Consumer Price Index (CPI) measures consumer price inflation. U.S. Bureau of Labor Statistics. “Consumer Price Index” Accessed March 10, 2022. The CPI consists of a basket of goods and services. It gives an estimate of the increase in average consumer prices across the economy.
The inflation rate results from the percentage changes in the prices measured by the CPI.
For example, if the CPI was at 262.2 one year ago, and now it is at 281.9, the percentage change from a year ago is 7.5%. This means, the year-over-year inflation rate is 7.5% as measured by the CPI. Federal Reserve Bank of St. Louis. “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Accessed March 10, 2022.
Another way of looking at it is that the average price of goods and services has increased by 7.5% in the last year. Or the purchasing power of the money has dropped 7.5%.
While there is some debate about the cause of inflation, it is most commonly associated with an expansion of the money supply. Economist Milton Friedman famously said that inflation is always and everywhere a monetary phenomenon. Friedman, Milton: Money Mischief: Episodes in Monetary History (1994), pp. 63.
So how does the money supply increase?
Central banks influence the money supply in several ways. They can do this through Quantitative Easing, Yield Curve Control or by monetizing debt.
Most commonly, central banks control the money supply by setting short-term interest rates. Under the fractional reserve banking system, banks can loan money into existence. When interest rates are low, it is more attractive for individuals and corporations to borrow money.
When you borrow money from a bank, the bank doesn’t give you money that it owns itself. The money it gives you is loaned into existence. It didn’t exist before the loan.
This is why low interest rates are a way to flush the economy with money. The lower the interest rates are, the more people borrow money and the more new money circulates.
Until 1933, the United States was on the gold standard. This means, all money was backed by physical gold and the value of the US dollar was pegged to gold at a fixed exchange rate of $20.67 per ounce of gold. National Mining Association. “Historical Gold Prices 1833-Present” Accessed March 10, 2022.
The gold standard prevented the United States government and the Federal Reserve from arbitrarily expanding the money supply. In order to expand the money supply, the United States government needed to hold more gold.
In the early 1930s, the United States and many other countries were struggling to recover from the Great Depression, one of the worst economic crises in history.
President Roosevelt took the United States off the gold standard in 1933. The American Presidency Project. “Executive Order 6102—Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government” Accessed March 10, 2022. About a decade later, global leaders drafted a new monetary system known as the Bretton Woods system.
As part of the Bretton Woods system, the United States held gold in its reserves and pegged the US dollar to gold at a fixed exchange rate of $35 per ounce of gold. Federal Reserve History: “Creation of the Bretton Woods System” Accessed March 10, 2022. All other countries held US dollars in their reserves and could redeem their dollars for gold at any time.
In 1971, president Nixon closed the gold window and severed all ties to gold. From then on, governments didn’t have any backing requirements for their currencies.
Their central banks could issue new money with less restrictions. This increased the fear of inflation. In the decades following the Nixon Shock, the US dollar lost 95% of its purchasing power. Statista: “Purchasing power of one US dollar (USD) in every year from 1635 to 2020” Accessed March 10, 2022.
Consumer prices rose significantly.
The Great Depression was a huge learning experience for governments and central banks. During the Great Depression, consumer prices sunk. When there are more goods and services than there are units of money in circulation, the prices of goods and services decrease. This is deflation.
Under the fractional-reserve banking system and in an economy that greatly depends on credit, deflation is viewed as something bad. Federal Reserve History: “The Great Depression” Accessed March 10, 2022.
Inflation benefits those who borrow money and it stimulates the economy by incentivizing consumption.
Deflation puts pressure on borrowers and can lead to defaults, credit crunches and reduced spending. This is why central banks aim for mild inflation and do whatever it takes to prevent deflation.
Most central banks, including the Federal Reserve, aim for 2% year-over-year inflation. Board of Governors of the Federal Reserve System: “What is an acceptable level of inflation?” Accessed March 10, 2022. Mild consumer price inflation is meant to incentivize borrowing and spending.
When money loses value with time, it is less likely that people will hoard money.
Borrowers benefit from inflation because they can pay back their debt with devalued money. Likewise, spending borrowed money or savings is beneficial because if people wait before spending the money, it loses purchasing power and will buy less goods and services.
Consumer price inflation is not an accident. It’s a desired outcome because it stimulates the economy. Central banks attempt to control inflation by controlling the money supply.
If consumer price inflation gets too high, central banks tighten their monetary policy by raising interest rates or tapering their money printing.
However, keeping inflation in check isn’t always a straight forward process. There are several examples in history when inflation got out of hand, such as the German hyperinflation.
Hyperinflation is a year-over-year inflation rate of 600% or more. Cagan, Philipp: The Monetary Dynamics of Hyperinflation, in: Studies in the Quantity Theory of Money (1956) This is the equivalent of a month-to-month inflation rate of 50%.
Zimbabwe and Venezuela are examples of recent countries that experienced hyperinflation.
While the year-over-year inflation rate in the United States reached a 40-year high and peaked at 7.5% in 2022, it is still far from the 600% year-over-year inflation rate required to qualify as hyperinflation.
Consumer price inflation rates above 2% are moderate or high and require a tightening of monetary policy by central banks.
One of the reasons why central bank need to keep an eye on consumer price inflation is because there is a psychological element to it.
If business owners expect increased inflation, these inflation expectations can result in manufacturers and business owners raising prices to keep pace with inflation. This can lead to a vicious circle where inflation expectations become a self-fulfilling prophecy.
As inflation expectations increase, business owners and manufacturers raise prices. The increased consumer prices lead to further expectations of higher inflation. This leads to additional price increases.
Governments sometimes resort to price controls to combat runaway inflation and control inflation expectations.
Apart from the Consumer Price Index (CPI) there are several other indices that aim to measure price increases over time.
This includes the Wholesale Price Index which measures the changes in the price of goods before the retail level. It includes raw materials and commodities used in the production process. The Producer Price Index measures price changes from the perspective of the seller.
The Consumer Price Index has been revised multiple times in the past. It was introduced in 1978. Throughout the last few decades, the basket of goods and services that the CPI measures has changed six times. U.S. Bureau of Labor Statistics. “Consumer Price Index Chronology” Accessed March 10, 2022.
Certain goods were removed over time which has led some people to believe that true consumer price inflation might be higher than measured by the CPI.
This resulted in the development of several alternative measurement tools for inflation. One of them is the Chapwood Index. According to the Chapwood Index, consumer price inflation is already in the double-digit range in many cities. Chapwood Index. “Chapwood Index – The Real Cost of Living Increase Index Vs Consumer Price Index” Accessed March 10, 2022.
In reality, we all have different inflation rates. Federal Reserve Bank of St. Louis. “What’s in Your Market Basket? Why Your Inflation Rate Might Differ from the Average” Accessed March 10, 2022. Depending on what types of goods and services you buy, your personal inflation rate is different from the average measured by the CPI.
Critics of inflation argue that it’s one of the biggest drivers of inequality in the world. According to them, inflation punishes those who live paycheck to paycheck or save money. At the same time it benefits people that own assets like real estate, stocks and commodities.
Consumer prices aren’t the only thing that inflate when the money supply expands. Asset prices tend to increase as well.
Landlords that own houses benefit from inflation because the value of their properties and rents increase with time. The tenants that don’t own any real estate have to keep up with rising rents.
Another criticism of inflation is that wages often don’t increase as fast as consumer prices. If the average inflation rate is higher than the average rate of wage increases, real incomes decline. Workers make more money, but they can buy less.
In other words, rich people that own assets get richer and the most vulnerable people that live paycheck to paycheck get poorer.
|↑1||U.S. Bureau of Labor Statistics. “Consumer Price Index” Accessed March 10, 2022.|
|↑2||Federal Reserve Bank of St. Louis. “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Accessed March 10, 2022.|
|↑3||Friedman, Milton: Money Mischief: Episodes in Monetary History (1994), pp. 63.|
|↑4||National Mining Association. “Historical Gold Prices 1833-Present” Accessed March 10, 2022.|
|↑5||The American Presidency Project. “Executive Order 6102—Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government” Accessed March 10, 2022.|
|↑6||Federal Reserve History: “Creation of the Bretton Woods System” Accessed March 10, 2022.|
|↑7||Statista: “Purchasing power of one US dollar (USD) in every year from 1635 to 2020” Accessed March 10, 2022.|
|↑8||Federal Reserve History: “The Great Depression” Accessed March 10, 2022.|
|↑9||Board of Governors of the Federal Reserve System: “What is an acceptable level of inflation?” Accessed March 10, 2022.|
|↑10||Cagan, Philipp: The Monetary Dynamics of Hyperinflation, in: Studies in the Quantity Theory of Money (1956)|
|↑11||U.S. Bureau of Labor Statistics. “Consumer Price Index Chronology” Accessed March 10, 2022.|
|↑12||Chapwood Index. “Chapwood Index – The Real Cost of Living Increase Index Vs Consumer Price Index” Accessed March 10, 2022.|
|↑13||Federal Reserve Bank of St. Louis. “What’s in Your Market Basket? Why Your Inflation Rate Might Differ from the Average” Accessed March 10, 2022.|