What is Inflation?

Nothing to be scared off...right? (5 min read)

Jan 6

Welcome to 2022!

We’re kicking off 2022 with a topic that has been in a news quite a bit lately - inflation. Inflation is a loaded word. Economists and news media alike debate inflation. But, how much do you really need to worry about inflation? We touched on inflation’s relationship to currencies. Let’s break it down in more detail today.

TL;DR

Inflation, or the rise in prices over time, is real, but it does not have to be scary.
Make sure your wages rise at least as much as inflation each year. If you’re a freelancer, consider raising your prices. If you’re a full time employee, make sure you get at least a 2% annual increase (but why not ask for 10%!).
Interest rates may rise this year. If you have a mortgage or car loan, make sure you have the lowest interest rate while you can still get it.

What is Inflation?

Inflation is the rise in prices over time. Inflation reduces your ability to buy stuff. Here’s an example.

I went to a movie theater for the first time in two years (I saw Spiderman, side note: it was worth it). The ticket cost $12.50. The first movie I saw in theaters was Space Jam, in 1996. Still today, it’s one of my favorite all time movies. These photos are evidence.

In 1996, one movie ticket cost $4.50.

My grandma took my sisters and I. Since movies cost $.50 when my grandma first started going, she felt this was expensive. To make up the cost difference, she snuck in snacks instead of buying popcorn at the store (a habit I still adhere to today). I still remember her large black purse stuffed with an apple and a kitchen knife to peel, slice, and share. I digress.

From 1996 to today, the cost of a movie ticket rose from $4.50 to $12.50. Most of the price increase comes from increased labor and rent costs and an overall better movie experience from new technology. And, some of it, roughly 30% (or $3.50 of the movie cost), is from good old inflation, or the general rise in prices over time.

Said differently, $4.50 in 1996 is equivalent to $8 today.

How Does Inflation Work?

Inflation is all about supply and demand.

The most iconic graph in economics. Thanks Thought Catalogue for the image.

In particular, inflation is about supply and demand of the US dollar. The Federal Reserve manages the supply of the US dollar, so the Fed, in part, manages inflation. Forgive my economic wonkiness for a second. You’re forgiven if you skip this next paragraph, just read this next sentence. Basically more money in the economy means a little more inflation.

When the Fed wants to boost economic activity, it lowers interests rates in hopes that people borrow more money to buy and invest more. When interest rates are already low, like today, the Fed can print money. The Fed loans this money out to increase the supply of money in the economy. This increased supply of money makes all of our dollar bills slightly less valuable. But, the FED knows that if this money is spent to grow the economy, economic growth will help combat inflation and be paid back in taxes. If the FED sees prices rising too much, it increases interest rates to reduce demand and slow inflation. Inflation is usually about 2% per year.

Inflation is also about supply and demand of specific items in the economy. Our economy is hyper interconnected. Remember when that ship was stuck in the Suez Canal for four months? If not, you probably remember the memes.

Deeba Shadnia @deebashadnia

🙃

Well, this four month blip caused shipping cost to rise because shipping supply through one of the most active canals in the world was at a halt, and demand for items was at an all time high. A huge drop in supply + a huge spike in demand = rising costs. And not just via ships, but by plane and freight too. This trickled through the economy. And all of a sudden your Amazon package delivery’s got a little more expensive, for someone.

The price spike was temporary, but if the Suez Canal closed for good, we’d likely see sustained increases in shipping costs contributing to overall economic inflation. Until there was a new innovation (drone delivery!) or increased supply (more planes!) to make up for it.

Why Does Inflation Matter?

The Suez Canal example highlights the inflation we’re (likely) seeing right now. The economy is still wacky from COVID. And prices are in flux because of spiky supply and demand. Also, the Fed printed money for COVID stimulus. If this wackiness keeps up, we’ll see longer term inflation or higher interest rates.

This all matters because when prices increase over time, our ability to buy items decreases. In order to keep up with inflation, your income need to increase as well.

If you’re a freelancer or consultant, think about increasing your price by a little bit each year, and maybe slightly more this year.

If you’re a full time employee, most companies are in the habit of increases wages by at least 2% each year to keep up with the average increase in prices. Don’t forget to ask!

And, if you have large loans, interest rates might rise this year because of inflation. Make sure you have the lowest rate you can get on your mortgage or car or student loan.

Economists and politicians like to debate if inflation is good or bad. Goods like Bitcoin and Gold are famously is “inflation proof” because there is a max supply available. Investors tend to buy these assets in times of inflation.

But, my takeaway is this. Inflation is not good or bad, but it is real.