Current Economic Conditions and the Prospect of Inflation

The Consumer Price Index (CPI), a common measure of inflation, grew at a 3.2% annual rate in April, the fastest rate since October 2008.1 For more than two years, the U.S. economy has experienced relatively low inflation, and the current rate remains below the 50-year average.2 Yet anyone who has been to a gas station or a grocery store recently may feel that prices are going up faster than the CPI suggests.

The CPI measures price changes in a market basket of consumer goods and services. Because prices for food and energy are generally more volatile than other prices, a narrower index called the “core CPI” excludes them. Core inflation, which is used by policymakers as an indicator of long-term inflation trends, grew at an annual rate of just 1.3% in April.3 This suggests that the recent increase in general inflation is due mainly to rising food and oil prices, wh

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ich have yet to work their way fully into prices for other goods and services.

A Slow-Growth Economy

Inflation is typically a by-product of economic growth. When an economy is growing, more people are working, spending money, and competing for a limited supply of goods and services, which can cause upward pressure on prices.

But things are a little different right now. Prices are rising during a period of slow economic growth. Political unrest in oil-producing nations in the Middle East and Africa has contributed to rising oil prices. Because oil is needed to produce most goods and services, higher oil prices can drive up the cost of doing business, which can cause companies to cut spending and payroll, pass higher costs on to their customers, accept lower profits, or some combination thereof. By one estimate, a $10 increase in the price of a barrel of oil reduces gross domestic product growth by 0.2 percentage points.4

Prices for important food crops have surged over the past year — corn was up 88%, wheat was up 76%, and soybeans were up 37% — not only because of growing demand from economies that are recovering faster than the U.S. economy, but also because higher oil prices are spurring demand for ethanol made from corn. These three grains are used in a multitude of food products, which could be why the U.S. Department of Agriculture estimates that food prices will jump between 3% and 4% in 2011 — whereas food inflation in 2010 was at its lowest rate since 1962.5 Food may play an even more critical role in the economy than oil. There are ways to cut back on energy use, but everyone needs to eat.

And then there are the problems in Japan, the world’s third largest economy.6 While this wealthy and productive nation struggles to recover from an earthquake, a tsunami, and a nuclear crisis — estimated to be the costliest natural disaster on record — the world will struggle to get by without Japanese exports (including 25% of the world’s silicon chips) and cope with reduced consumer demand from Japan’s citizens until they get their lives back on track.7 Although there may be a construction boom in Japan, it will likely consume resources that supported other industries. One bright side is that Japan may use less oil in the near future, which could help bring down prices.

Limited Means

Unfortunately, when inflation is caused by something other than economic growth, policymakers may have limited means to combat it. The Federal Reserve’s typical response to inflation is to raise interest rates, in effect putting a brake on economic growth. But higher oil and food prices can also slow the economy, so raising interest rates might only make matters worse.

If you lived through the 1970s, you may recall the term stagflation, which was coined by economists to describe an unprecedented period in which the economy was experiencing a combination of slow growth, high inflation, and rising unemployment. The stagflation of the 1970s may have been caused by extreme oil price increases in the early 70s. It wasn’t until the Federal Reserve raised interest rates into the double digits that the cycle of stagflation was broken, but the Fed was blamed for causing a deep recession in the process.8

How Does Inflation Affect You?

It’s not clear whether the U.S. economy is entering a period of higher inflation. There are signs that the rise in energy and food prices may be slowing. The 3.3% rise in gas prices in April was the smallest increase since November 2010, and the 0.4% increase in food prices was half that of March.9 A drop in energy and food prices might free up more income for discretionary consumer purchases, which could help stimulate the economy.

But even a low inflation rate can pose risks to your finances over long periods. Consider that a 3% inflation rate could cut the spending power of a dollar in half in 24 years, according to the Rule of 72. Failing to account for inflation when projecting how much income you expect to need in retirement could cause you to set aside too little of your current income or invest too conservatively. By the time you reach retirement age, it could be too late to fix the problem.

The relatively low inflation rate the United States has enjoyed over the past few years may have lulled you into believing that inflation does not pose a long-term risk. If your long-term outlook doesn’t account for the risk of inflation, it may be time to consider adjustments that may help your portfolio keep pace with rising prices.

1, 3) Bureau of Labor Statistics, May 13, 2011
2) Thomson Reuters, 2011 (Consumer Price Index for the period 12/31/1960 to 12/31/2010)
4, 7) The Wall Street Journal, March 24, 2011
5) The Wall Street Journal, February 25, 2011
6) International Monetary Fund, 2011
8) Investopedia, 2011
9) msnbc.com, May 13, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek Naperville Financial Planning an/or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.