What Inflation Really Means
In the corresponding episode of our Money Tips No One Told You Podcast, we spoke with Anthony Greco, Professor of Economics at the Department of Economics and Finance at the University of Louisiana at Lafayette. He graciously agreed to speak with us about recession and inflation. Below is our conversation.
Q: What is inflation? What causes it?
A: Inflation is the persistent overall increase in prices, in average prices. And we usually measure it over a year's time since we say prices continue to rise over that period of time. And it's an average price. Of course, when we say a rate of inflation, whatever it is, it doesn't apply to every single good and product out there in the economy. It's just an average figure.
As a matter of fact, it comes from is the so called market basket of goods that the government assumes that the typical consumer will buy. And it's made up of several categories, but it's 300 different products that they keep track of over a period of time and see what they're doing in terms of their prices.
It covers areas you would expect housing, transportation, food. And by the way, housing and transportation are the two largest components of the inflation index that we look at. And, of course, it also has personal insurance, healthcare, entertainment, education and a miscellaneous category.
The 300 products are readily available for inspection, if you go to the BLS.gov website.
And I mentioned housing is the major one that makes up-- the items under housing makeup about 32% of the total index. We usually call it the consumer price index. People have probably heard that term before. The cost of living index is another word we use for it, but again, it does apply to those 300 products which can be taken out and changed and so on over time at the government's discretion. And whenever you have an index, in this case, we call it the Consumer Price Index, focusing on consumption spending, you have to have a base year on which to translate those indexes for all given years in the base year. We could say, essentially, is 1982. And we can take a look at years before that and years after that and see what it does. So we'll always have to kind of judge our rate of inflation in terms of what it was relative to the base year if that hopefully makes sense. But any index is always going to be reliant on establishing a place to start a base year.
Q: How is the base year determined?
A: It's the government that does that at their discretion. I mean, that they will take a look at the various years and see what activity's been going on, and if it's an outlier, they won't worry about it. But if it looks like it's a reasonably good year to use, they will. They actually do use 1982 through 1984.
Q: 1982 seems like so long ago, but I guess you probably have a before and after.
A: Yeah, well they did use to do-- yeah, they've adjusted it over time. It used to be 1957 for many years. So one of these days and they think it's appropriate, they'll change it.
Q: That's fascinating. I honestly did not know that's how the consumer price index was made up.
A: Right. Those are the major categories, and all you're spending really kind of comes under that umbrella, especially when you throw in that last one of other goods and services of miscellaneous categories, and that's only about 7% anyway, typically. And those percentages will pretty much be the same. And when you think about it, housing with 32%, I've always kind of used that as a gauge. You probably don't want to put any more than 1/3 of your income into house payments. So that's a good number.
Q: That's a very good point. Absolutely, the place you want to stay. And it does make sense too, when we're seeing inflation, people will use the term it's across the board. And I guess when you are considering 300 products that it is across the board, literally.
A: I do want to emphasize that, of course, no government number, or any government statistic, or any non-government statistic are going to be perfect. There are going to be imperfections. There are going to be some based on certain assumptions and based on certain data availability and things change over time. And that's what addresses it to your question, you said, about how do they determine that? Well, they're looking at things in time. Over time, they've taken out some products from that 300 because they're no longer popular and added new products. For instance, these days you'd be adding a lot of more technological products and things that would go along with people's lifestyles.
Q: So I guess it would be reasonable to assume that at some point in the future they will move that year sort of up closer to the year we're in now.
A: Right. Yeah, I would certainly think so.
Q: What causes inflation to happen?
A: I guess the first and most prominent, the cause of inflation, we say, is demand-pull, or P-U-L-L, inflation. Demand is rising faster than our capacity to produce and so it raises prices. If anybody can visualize in their mind a diagram where there's a downward-sloping demand curve or line and an upward-sloping supply line. Where they intersect, we have equilibrium.
When the demand increases or goes out to the right, and supply doesn't do very much, then it's going to pull those prices up. So it's demand or pull inflation. When the economy is really heated up and the consumers-- and we know these days there's so many goods and services out there and so many amenities people want to have and technological games and devices and so on. And we live in an advanced society and advanced economy and people want to get the latest and the greatest and so demand is usually going to be fairly robust level. It's going to pull prices up. So that's the major reason.
Another important reason, what we call it coming from the other side, we talked about demand, the buying side. Well, the cost side would be what supply's all about. It costs suppliers or producers something to produce goods and we get this thing called cost-push inflation, P-U-S-H, cost-push. So demand pulls in one direction and cost pushes in the other. So if business firms prices go up, it cost them more to produce, they're going to have to raise their prices. And that can be illustrated by if you just think in terms of a labor union negotiating with a manager or management firm, they're going to bargain for higher wages and that's going to come from the supply side. That is really typically the biggest expense that a business firm will have will be their wages and benefits and things like that to their workers be it unionized or non-unionized.
And so that is going to be a major cost for business firms and then, of course, the cost of energy. You can't forget about that. That's a major factor certainly and is playing a big role these days in inflation. Energy, and other inputs that the firm has to use, what resources or things they put together to get some output. If those things go up in high price, labor, materials, and energy in various forms and their costs go up and they have to push up their prices. So those are the two major causes of inflation.
Q: A lot of us are struggling with our pocketbooks right now trying to make ends meet because you may get a raise at work but then you find it sort of eaten up by all these rising costs. Do you have any suggestions of what people might could do to sort of help their personal finances during a time like this?
A: Well, first of all, the money you get in your salary, whatever it is we call it, the money income or nominal income and that's been going up admittingly. But the problem is inflation has been going up even faster and so we get the real essence of how well off you are would be what we call real income, emphasizing what you can really do with that income.
If you take your money income and divide it by the rate of inflation, the CPI, you get your real income. And of course, if you just picture that numerator up there is your money income and that might be going up say 5% or whatever. But the denominator underneath there is the price level, CPR, that's going up 8 or 9% then you're really losing purchasing policy.
That real income as that denominator goes up, is going to fall. And so that's why sometimes people don't realize that. But I think they are more and more recognizing that. Money income, "Hey, we're doing okay." And sometimes some government people will say, "Oh, the money income is going up." But that's only half the picture. It's what you can buy with that money income, the real income. What can you translate that into? How many pounds of margarine? How many groceries and things you can buy?
Now, people are noticing, of course, you're not buying as many groceries. If they had a fixed budget to begin with, that's not going as far. They have to increase that budget. Or what they might do to help deal with inflation, of course, is to make some substitutions and maybe don't buy the best brand, maybe buy the store brand. So it's a little bit cheaper, maybe 10 cents a pound or 10 cents a box, whatever the case might be.
So you're saving a little bit here and there, but it does add up over time because it's a major expense. And people have to go to the grocery store quite often, probably every week, to replenish the basics and then to get other things. A lot of people have done this too. Stop eating the steak and eat the ground meat and eat the chicken and things like this. Take less entertainment outings, go to the movies, or stay home and watch TV, or rent a movie, or take shorter vacations, or no vacation. I know people have done this. They're making subs. And you do this, of course, on an ongoing basis. And you probably have to cut further and further as you go back there. As long as the inflation persists and as long as your income is not rising as fast as the price level, then you're going to find that you'll have some options.
Now you may reach a point where you cut to the bone and you can't do any more. But if you keep thinking about it, maybe we don't need this, maybe we don't need that. Maybe we can eat less ice cream and things like, that so people can make it. That's going to vary from person to person depending on your income, and the number of people in the family, that kind of thing. But you can make adjustments. It's called substitution. If you do that on a continuing basis, on a permanent basis, set up a budget and you'll have to probably revise that budget downward as long as the inflation persists. It's just a matter of keeping on top of it. And it's not an easy process and some people have trouble with it, that's for sure.
Maybe on a temporary time period you won't be able to eat as you like. You go out less, of course. Eating out, of course, is a double whammy. It costs money, of course. You can eat cheaper at home, plus you can't usually eat as healthy unless you're eating at home. So I'd say buy more vegetables - although they're not cheap either - and fruit and whatnot, have some meals without meat, things like that. You can have good nutritional values and consult nutritionists and websites and things like that. They have a lot of good ideas about meals that will go over a long way and maybe cook a big portion of something and eat it a couple to three times a week. It doesn't sound as exciting. It's so nice to have all the variety of stuff that we have in our society, but sometimes you just have to tighten the belt.
Q: One thing I'm noticing when you're talking about this, and I think what some people don't consider, is as you tighten your belt and you kind of stop doing things like going out and buying this sort of lower priced products and whatnot, then that's also going to have a trickle effect to those industries. Restaurants and businesses may suffer with less people spending money, etc.
A: Right, exactly. It's all tied together. We cause an effect, I guess. Things happen to us and we make things happen in the other direction. And of course, with that lockdown we had, a lot of residents and businesses went out of business and did not come back. And so that also tends to put a clamp on a lot of availability of products. We know the supply chain right now is still disrupted so that means supply was moving back and cutting down. And when that supply gets reduced, it also tends to put pressure on price. So that's another factor we can say that cost pushing, that extended supply crunch that we've had.
Q: It truly does affect everything. And I think a lot of times when we're in our homes just trying to make ends meet or adjust that budget or whatever, and sometimes you don't think about just how deep all this goes and how much it effects and how it's all tied together. How do you stop inflation? How do you slow this down?
A: Well you could have a situation where the reduce the supply money, the Federal Reserve could do that and that would tend to drive interest rates up and so on, and it tends to cut back on spending. That would tend to affect the demand side, and so that would put a brand take on it in that respect. The other thing would be is if we could finally have some of those businesses come back, and we can take away some of the restraints that we've had on energy and things like that and loosen that supply chain, make the supply chain work a little better for us and things like that.
So it's really from both sides trying to decrease demand, getting people to decrease their spending. But people are doing it automatically anyway. They're driving less, using cheaper types of gas and whatnot. So that's cutting back on demand. That takes the pressure off of the demand pool inflation. And if we can get the supply chain going back and take some of the restraints & regulations off of the energy production and so on, that will give some relief on the supply side.
Supply can increase and then also when that increases, that will put lower pressure on price. Reducing demand and increasing supply in effect, in a general sort of statement, is what happens. And then specifically we're talking about taking away government regulations, probably lowering taxes. It's not a good idea to raise taxes when you already have people struggling and you already have a recession. So lowering taxes, lowering regulation.
Regulation costs money. No matter if it's good or bad regulation. It always costs money. It imposes additional requirements on business firms and I have to hire additional people and fill out different reports and go to different meetings and you have to employ a bureaucracy to enforce it and so on and so forth. It's a costly thing. I don't say all regulation is bad, but there's a lot of it that we probably can do without and will tend to reduce costs. And so that would be another factor in there.
We truly enjoyed our conversation with Mr. Greko. Our next podcast continued our conversation concerning inflation. We hope you will check that out as well.