Inflation 101

An inflation objective

Inflation is a general rise in the prices of things we buy. When people have the money to buy more products than can be produced, it creates an imbalance, prices go up, and the result is inflation.

Inflation can reduce the purchasing power of your money. With inflation much higher than the FOMC’s 2 percent inflation objective, workers whose wages don’t rise as fast as prices may have problems paying their bills. And people on fixed incomes can suffer because their incomes might not adjust completely and they would not be able to buy as much as they could before.

With inflation lower than the objective, it is likely that the economy isn’t firing on all cylinders, and businesses will try to reduce their costs to maintain or regain profitability. One way they might do this is by increasing efficiencies, such as through layoffs. Another way could be through lower wage growth. In the extreme, if this behavior is replicated throughout the economy, unemployment is likely to rise while both wages and prices are lower. Efficiencies and lower wage growth can then reinforce the downward movement of prices.

We do want to have a bit of inflation. To borrow the theme from Goldilocks, the FOMC’s 2 percent longer-run inflation objective seeks a balance that is “just right” to keep the economy humming along. Not too hot (high inflation) and not too cold (deflation). A 2 percent objective sets an expectation and makes it less likely that the economy will experience deflation if it takes a turn for the worse.