This article is an introduction to the fundamental economic concept of consumer price inflation. For an advanced discussion of asset price inflation in the real estate market, see the first tuesday article, Beyond the basics: asset price inflation in the real estate market.
Fluctuation in the price level of goods and services
Inflation is a word that is often bandied about freely, meaning different things to different actors in the economy. At times, the concept is considered mystical and used with a lack of confidence in understanding, as is often seen with the gold bugs.
The truth about inflation is that, at its core, it is a very basic fundamental of macroeconomics, even while it has a profound and complex effect on both the nation’s and California’s economy in particular.
There are two basic types of inflation:
- consumer price inflation; and
- asset price inflation.
Although the two are intertwined by the dollar (real estate is a dollar denominated asset), an important distinction must be drawn between the two concepts. It is crucial to first have an understanding of consumer price inflation before moving on to asset inflation and its relationship to the real estate market.
Consumer price inflation is, simply put, an increase in the general price level of all goods and services in the economy – everything we buy to consume. While it includes rent movement in housing, it does not include the price movement of the underlying asset, the home itself, which is an element of real estate price inflation that is addressed in detail in the second part of this series.
The general price level is the average price of all goods and services sold in the economy calculated over a given period of time. The time period can be any interval, from one day to one month to a year. Most changes are reported as the rate of inflation that has taken place over the past 12-month period.
Changes in the general price level are measured and indexed as a figure by the Bureau of Labor Statistics. This figure is reported in a chart known as the Consumer Price Index (CPI). Thus, the CPI measures and tracks the rate of consumer inflation, which is simply an index of fluctuations in the general price of a huge selection (often referred to as a basket) of consumable items – goods and services.
Where does inflation come from and why do we care?
In an economy of fiat money, which is an economy where the currency;
- is controlled by a central bank;
- is backed by the full faith and credit of the national government; and
- has no direct tie to an underlying commodity, such as gold, or a peg to another currency,
inflation is fundamentally a result in an increase of the fiat money supply.
The Federal Reserve (the Fed) dictates the money supply, which is the amount of money printed by the U.S. Treasury (and delivered directly to the Fed) in addition to money created by the Fed placed in circulation as credit granted to banks.
Editor’s note — There are competing views on the causes of consumer price inflation. For the purposes of the discussion, we are here referring to a basic understanding of inflation known as the monetarist view. A further discussion of the expanded Keynesian view of inflation, which incorporates issues of supply and demand among other factors, will be discussed in part II of this article series.
From the monetarist’s view, if the supply and demand for goods and services remain at a constant, that is to say that there are no particular issues of scarcity or abundance in any of the consumer goods and services being sold and bought (exchanged in the marketplace), an increase in the amount of money in circulation will result in inflation. Note that this is not necessarily due to an increased demand for or a lack of supply of goods.
Rather, an increase in the amount of money in circulation results in each dollar a consumer spends as being capable of purchasing a smaller percentage of whatever good or service they are after. This is also often thought of as too many dollars (not people) chasing the same amount of goods and services.
In essence, as the general price level increases by way of an excess in the money supply, the consumer’s purchasing power decreases, resulting in a dollar that is worth less today than it was the day or the year before. One must keep in mind that in order for inflation to occur, the dollars must be in circulation, not stored in reserve rendering them unavailable for spending.
The Federal Reserve’s role
The Fed plays a very important role in controlling inflation in the U.S. economy. In this economy of fiat money (as are all currency- based economies today), the Fed controls the money supply as a matter of our national monetary policy.
One of the Fed’s primary goals is to keep inflation at a low but steady rate, presently around two percent per annum (but the Fed may have to let it rise to stimulate jobs). In essence, the Fed controls inflation by controlling the amount of money in circulation; It has several tools at its disposal to do this.
If the rate of inflation rises above their target level, the Fed responds by taking the excess money out of circulation. They withdraw money from the economy by:
- raising the reserve requirements on private banks for deposits with the Fed, thereby leaving private banks with less money to lend; and by
- raising the interest rate charged to private banks for borrowing funds from the Fed (which the Fed alone is authorized to “print”).
Of course, this also works the other way around: in the event of disinflation, also thought of as a decline in the rate of inflation below the two percent target, or worse, deflation, the Fed will lower reserve requirements on private banks and decrease interest rates paid by the private banks on loans from the Fed (and others) in the expectation of increasing the amount of money in circulation.
As a last resort, the Fed may also buy government bonds held by private banks and others, thereby directly injecting cash into circulation, a money-pumping process semantically known as quantitative easing or QE.
All of this monetary policy adds up to the Fed fulfilling their mandate to maintain economic growth through:
- stable consumer prices; and
- stable employment.
You will notice, again, that neither of these monetarist tools take into account (or would be very efficient) when dealing with extreme examples of an imbalance in supply and demand, called disequilibrium.
For instance, during times of war or scarcity in a particular commodity, say oil, these macroeconomic monetary interventions are essentially impotent in effecting any kind of price equilibrium. Thus, these shocks are left to work their way through the economy until they no longer drive prices up or down (the market is believed to “correct” itself).
While consumer price inflation is generally considered to be unaffected by price movement in the real estate market, since real estate is bought and sold with the dollar (dollar denominated asset), the two are indeed related. For a complete exposition of the relation between consumer price inflation as well as the distinct behavior of real estate price inflation, see Part II of this article series, Beyond the basics: asset inflation in the real estate market.