When inflation is good

Inflation is good when it is mild. There are two situations where this occurs. The first is when inflation makes consumers expect prices to continue rising. When prices are going up, people want to buy now rather than pay more later. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. It creates a virtuous cycle, boosting economic growth.

The second is when it removes the risk of deflation. That’s when prices fall. When that happens, people wait to see if prices will drop more before buying. It cuts back demand, and businesses reduce their inventory. As a result, factories produce less and lay off workers. Unemployment rises, leading to wage deflation. Workers have less money to spend, which reduces demand even more. Businesses lower their prices. That makes deflation worse. For this reason, deflation is even more corrosive to economic growth than inflation.

Prices fell 10 per cent during the worldwide Great Depression.

The Federal Reserve has set the official inflation target at 2 per cent.1 On August 27, 2020, the FOMC announced it would allow a target inflation rate of more than 2 per cent if that will help ensure maximum employment. It still seeks a 2 per cent inflation over time but is willing to allow higher rates if inflation has been low for awhile.

That's for the core inflation rate. It strips out volatile gas and food prices. It is also the year-over-year rate, not the month-to-month rate. Former Fed Chairman Ben Bernanke was the first U.S. Fed chair to set an inflation target.

Inflation targeting spurs demand by setting people's expectations about inflation. They believe the Fed will make sure prices keep rising. That spurs them to shop now before prices rise even more.

The nation's central bank changes interest rates to keep inflation at around 2%. The Fed will lower interest rates to boost lending if inflation does not reach its target. The Fed will raise interest rates if inflation exceeds the Fed's target. Inflation targeting has become a critical component of monetary policy. 

If inflation is greater than 2 per cent, it becomes dangerous. Walking inflation is when prices rise between 3 per cent to 10 per cent in a year. It can drive too much economic growth. At that level, inflation robs you of your hard-earned dollars. The prices of things you buy every day rise faster than wages. Thanks to walking inflation, it takes $24 today to buy what $1 did in 1913.

Galloping inflation occurred during the 1980s. It prompted President Ronald Reagan to famously say, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman."

It took double-digit interest rates and a recession to stop galloping inflation. Thankfully, it hasn’t returned since then. If inflation is greater than 2 per cent, it becomes dangerous. Walking inflation is when prices rise between 3 per cent to 10 per cent in a year. It can drive too much economic growth. At that level, inflation robs you of your hard-earned dollars. The prices of things you buy every day rise faster than wages. Thanks to walking inflation, it takes $24 today to buy what $1 did in 1913.

thebalance.com