When prices rise for energy, food, commodities, and other goods and services, the entire economy is affected. Rising prices, known as inflation, impact the cost of living, the cost of doing business, borrowing money, mortgages, corporate and government bond yields, and every other facet of the economy.
SEE: What You Should Know About Inflation.
Inflation can be both beneficial to economic recovery and, in some cases, negative. If inflation becomes too high the economy can suffer; conversely, if inflation is controlled and at reasonable levels, the economy may prosper. With controlled, lower inflation, employment increases, consumers have more money to buy goods and services, and the economy benefits and grows. However, the impact of inflation on economic recovery cannot be assessed with complete accuracy. Some background details will explain why the economic results of inflation will differ as the inflation rate varies.
Economic growth is measured in gross domestic product (GDP), or the total value of all goods and services produced. The percentage of growth or decline, compared to the previous year, is adjusted for inflation. Therefore, if growth was 5% and inflation was 2%, GDP would be reported at 3%.
As prices rise, the value of the dollar declines, as its purchasing power erodes with each increase in the price of basic goods and services.
The Cost of Borrowing
Low or no inflation, theoretically, may help an economy recover from a recession or a depression. With both inflation and interest rates low, the cost of borrowing money for investments or borrowing for the purchase of big ticket items, such as automobiles or securing a mortgage on a house or condo, is also low. These low rates are expected to encourage consumption, say some economists.
Banks and other lending institutions, however, may be reluctant to lend money to consumers when rates of return on loans are low, which decreases profit margins.
The U.S. Federal Reserve, which sets interest rates on government securities - mid- and long-term Treasury notes and shorter-term bills - has promised to keep rates at very low levels until 2014.
This assurance of low rates for the next two years is designed to stimulate the economy and keep inflation rates at a guaranteed level. The business community, including large, medium and small operations, know that certain fixed costs will remain constant, at least for that designated time period.
Businesses can therefore plan their borrowing, hiring, marketing, improvement and expansion strategies accordingly. Investors, likewise, know roughly what government and corporate bonds and other debt will return, since most of these instruments - if not so-called junk bonds - are pegged to Treasury yields.
However, economists differ notoriously in their opinions. Some economists claim that a 6% inflation rate for several years would help the economy by helping to resolve the U.S. debt problem, lifting wages and stimulating economic growth.
The Consumer Price Index
The standard measurement of inflation is the government's Consumer Price Index (CPI). Components of the CPI, a "basket" of certain elementary goods and services such as food - meat, vegetables and bread, for example - energy, clothing, housing, medical care, education, and communication and recreation. If the average price of all goods and services in the CPI were to go up 3% over the previous year's level, for example, then inflation would be pegged at 3%. This also means that the purchasing power of the dollar would have declined by 3%.
Hard assets, such as a home or real estate, often increase in value as the CPI rises; however, fixed income instruments - Treasuries or bank Certificate of Deposits, for example - lose value, because their yields don't increase with inflation. One notable exception, however, are treasury inflation protected securities (TIPS). Interest on these securities is paid twice yearly at a fixed rate as the principal increases in step with the CPI, thus protecting the investment against inflation.
The Bottom Line
Controlled inflation, no higher than 6% and perhaps somewhat lower, may have a beneficial impact on economic recovery, according to some economists, while inflation at 10% or above would have a negative impact. If the U.S. continues to increase its debt and continues to borrow money via Treasury issues, it may have to deliberately inflate its currency to eventually retire those obligations. Investors, retirees or anyone with fixed income investments will in effect be paying down those obligations, as their holdings decrease in value as prices rise.
SEE: The Importance Of Inflation And GDP.