How inflation affects you and the economy

In June, the Bureau of Labor Statistics (BLS) announced that inflation rose 5.4 percent in the last 12 months. Despite the claim that inflation was transitory, prices have continued to rise, prompting the Federal Reserve Bank to accept that inflation will likely persist.

Specifically, yesterday Jerome Powell announced that it is highly likely inflation will continue to rise.

As the reopening continues, bottlenecks, hiring difficulties, and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expected.

So what does this mean for you and the economy? Here is what inflation means.

Your dollar will buy less

Inflation is defined as a persistent rise in the price level. That is, money buys less than it otherwise would if the price level stayed the same. Since, unlike with isolated price increases, there is less opportunity to substitute for cheaper options, inflation can be especially taxing for low-income individuals.

Some groups have, of course, touted the seemingly positive fact that wages are rising due to inflation. This is misleading, however.

If wages are rising but at a slower rate than the rise in the cost of living, individuals are poorer in the longrun. In fact, the BLS announced that while wages have risen in the last 12 months before June, inflation has risen at a faster pace, effectively giving workers a pay cut.

The same applies to savings and returns from investments. A decline in the purchasing power of money erodes the value of money, including savings. Inflation may also reduce the value of your investment returns, especially if interest rates do not keep up with the level of inflation.

Effects of inflation may, of course, not be significant at lower rates. However, over time and at higher rates, it is hard to deny such effects.

There will be more uncertainty

Uncertainty is especially pronounced when inflation is volatile. When consumers and producers have a hard time predicting inflation, economic transactions become more costly.

Lenders may, for example,increase the cost of lending to businesses, i.e., add an inflation risk premium, which may affect capital formation in the economy and overall business planning. Moreover, individuals invest resources and time in trying to shield themselves from the impacts of inflation, instead of focusing on more productive activities.

In addition, uncertainty about inflation has the potential to mess with the price mechanism that directs decisions in the market. Normally, changes in prices are a signal to producers to either invest more or fewer resources into certain products.

However, with inflation, “producers face a new problem: changes in prices may be due to changes in people’s underlying preferences and knowledge, or they could be the (temporary) result of inflation.” This may lead to the misallocation of resources if producers are unable to decipher such differences.

Conclusion

All in all, inflation is not without its costs. And the longer high rates of inflation persist, the higher these costs will be.