9/3/2010
By Conley Turner, Research Analyst

There has been much of talk about inflation of late and the prospects of it rearing its head in the not too distant future.  As such, it is useful to have a clearer picture as to what constitutes this economic phenomenon and what can be done about it once it arrives.

In essence, inflation is more or less the pace at which prices rise over the course of time.  A simple illustration would be the increase in the price of a loaf of bread from say five years ago.  The variance in the price between then and now can largely be attributed to impact of inflation.

There are two categories under which inflation falls.  These are namely cost push and demand pull inflation.   Cost push inflation generally occurs when there is an increase in the inputs required to produce goods and services.   These increases are then passed onto the end user in the form of price hikes.  An example would be utility companies increasing prices due to the overall increase in energy prices. The significant increase in wages without a corresponding increase in demand is also a cause of this type of inflation.

Alternately, there is demand pull inflation when there is a lot of money chasing a limited supply of goods and services.  The typical result is the sharp increases in the prices of those said goods and services.  A country's central bank increasing the money supply can create the conditions necessary for demand pull inflation.  If the supply of those goods and services remain constant, their prices will tend to rise.  

The measurement of inflation occurs by taking items that are representative the macro economy and putting them into a basket. The overall cost of this market basket is computed and then compared over time. There are two methods by which inflation is measured in the U.S.  First there is the Consumer Price Index (CPI) which measures the variance in prices paid by consumers for a market basket of goods and services.  The basket includes, among other things, food, clothing, automobiles and gasoline. The other inflation measure is the Producer Price Index (PPI).  This encompasses a number of indexes that calculates the differences in selling prices over time by the producers of goods and services.

A nominal amount of inflation is a necessary ingredient for a healthy economy as it conveys that actual economic growth is occurring. In fact, a country can withstand a high rate of inflation over a period of time and still not suffer any permanent damage to its long range economic prospects.  Nonetheless, a prolonged bout of inflation can result in disequilibrium and an overheated economy or even hyperinflation.

One of the tools used by countries to combat inflation is to increase interest rates. This is in order to provide curbs to any excess in business and consumer borrowing and spending.  In the U.S. there has been an infusion of money into the economy by the Federal Reserve in order to provide stimulus out of the Great Recession. 

As such, the prevailing forecast is for this record level of money creation to eventually result in a weaker dollar and an inflationary environment.  In the immediate future however, the prospect of inflation is unlikely as the broader US economy and the recovery remains fundamentally weak.

Conley Turner
Wall Street Strategies