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What Americans should know about inflation as it hits a 30-year high

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(NEW YORK) — Americans across the country are seeing higher prices at the mall, grocery store and gas pump, causing new pain for their pocketbooks right as the holiday shopping season is set to commence.

Inflation has risen at its highest rate in three decades, data released by the Labor Department earlier this week indicates, as consumer prices soared by 6.2% compared to the same period last year. This is the biggest one-year jump seen in the government’s consumer price index since 1990.

As inflation tightens its grip on the economy, the Federal Reserve has begun walking back previous assurances that it will be a temporary, post-pandemic blip. Economists at Goldman Sachs warned in a research note last week that inflation is “likely to get worse before it gets better,” and could persist well into next year.

Many Americans now are too young to remember the pain and uncertainty inflation wreaked on the country in the 1970s, a period economists dub as “The Great Inflation,” when wages and prices snowballed and the purchasing power of savings dwindled before a painful correction that led to a recession and double-digit unemployment rates in the early 1980s.

A generation later and under very different circumstances, prices are again surging at a rapid clip. While economists say policymakers now are much better-equipped to respond to inflation than the last time it struck the U.S., consumers are already feeling the pressure — particularly those with limited means to absorb higher prices for essentials.

Here is what Americans should know about inflation, why it is so high right now and when they can expect relief.

What is inflation?

“Basically, inflation measures the rate of increase in consumer prices,” Itay Goldstein, a professor of finance and economics at the University of Pennsylvania’s Wharton School of Business, told ABC News. “At the end of the day, it measures the extent to which the cost of living is higher.”

The Federal Reserve, America’s central banking system, defines inflation as the “increase in the prices of goods and services over time.”

“Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services,” the Fed states. “Rather, inflation is a general increase in the overall price level of the goods and services in the economy.”

Policymakers evaluate changes in inflation by monitoring several different price indexes. One of the most commonly used barometers of inflation is the Consumer Price Index, which is released by the Labor Department each month and measures the average change over time in the prices paid by consumers for a market basket of goods and services.

The CPI has surged by 6.2% since last October, according to DOL data. The so-called “core index,” or measure for all items except the more volatile food and energy indices, rose 4.6% over the last 12 months, the DOL’s data indicates. This represents the largest one-year increase since August 1991.

“Inflation means that your dollar won’t stretch as far,” Laura Veldkamp, a professor of finance at Columbia Business School, told ABC News. She used Christmas presents as an example, saying that if you wanted to buy a sweater as a gift last year for $100, this year, that price might be closer to $105.

If the prices of some goods and services increases and the prices of others fall, but the overall prices that consumers pay for the bundle of goods and services does not increase, then this is not referred to as inflation.

What causes inflation, and why is it so high right now?

Inflation is determined by the interaction of total demand (aggregate demand) and total supply (aggregate supply) in the economy. If total spending in the economy exceeds the total amount that the economy can produce, then production cannot increase but instead prices will rise.

“When you have a higher demand, the price tends to go up. When you have lower supply, the price also tends to go up,” Goldstein told ABC News. “At the end of the day, the price is a combination of these forces.”

But monetary policies also affect inflation, he said. Keeping interest rates low and injecting a lot of money into financial markets — actions the Fed took to help buoy the economy during the health crisis — can also be linked to the high inflation we are now seeing, according to Goldstein.

Stimulus checks boosted total demand, and at the same time the ability to supply goods and services have been restricted by the pandemic. While the impact of stimulus money on inflation is now waning, many of the other factors that created these imbalances between supply and demand are persisting, Goldstein said.

“People feel that they have money to spend, they want to spend it on things that they haven’t done in the last year,” Goldstein said. “You basically have limits on supply at the same time that you have an increase in demand, and that certainly pushes prices up.”

Veldkamp also stressed the impact that the supply chain issues have on driving up prices. Using the Christmas sweaters metaphor again, Veldkamp added, “Let’s say those Christmas sweaters are stuck on a boat somewhere, then the few sweaters that are here, lots of people want them.”

“So, stores can charge more for them, because they’re scarce,” she explained.

Costs of doing business have also risen during the pandemic, Veldkamp noted, as companies had to spend more to make it safe to do business while COVID-19 spread.

“Lastly, workers are asking for higher wages,” Veldkamp said. “Which may be perfectly justified, but it does make the cost of doing business higher. Say if a restaurant waitstaff wants a 5%, 10% raise, those restaurants are going to have to pass some of that additional cost to their customers, otherwise they won’t turn a profit.”

The economic phenomenon known as the “wage-price spiral” can develop when prices increase and then workers ask for higher wages — which can then lead to further increases in the prices of goods and services, and these can lead to a further increase in wages and so on. In this manner, inflation can become a self-fulfilling prophesy of sorts. This ever-intensifying wage-price spiral characterized the U.S. economy in the ’70s, ultimately resulting in double-digit inflation.

How does the rise in inflation affect consumers?

If consumers’ wages increase with the rise in prices, they should be able to continue purchasing the same amounts of goods and services as usual. This will not be true for all consumers, however, meaning some may struggle to purchase what they used to.

“Your dollar doesn’t go as far, so it’s going to be a little bit harder to buy all the things on your list with the same amount of money,” Veldkamp said. “And that sounds pretty bad, but at the same time, wages are rising, and returns rise with inflation, too.”

Goldstein reiterated that the effect of inflation on consumers is that “when prices go up, people will have to pay more for whatever they want, and as a result, they can afford less.”

He also mentioned the wage-price spiral to show how inflation “might get out of control.”

“What could happen is everyone has to pay more, so they go back and start demanding increases in wages,” he said. “And if wages start to go up, then the whole process can get additional amplification and kind of like a snowball eventually gets very tough to control — and then it becomes very difficult to bring things back.”

How does inflation impact the stock market?

Stocks are a claim on the future earnings of firms, so in principle, firms should be able to raise their prices in line with inflation so their earnings should not decrease.

Historically, however, inflation has been linked to negative impacts in the stock market. One reason for this is that inflation restricts the ability of the Federal Reserve to take action. After stricter policies defeated the spiraling inflation in the U.S. in the early 1980s, the Fed has been able to ease monetary policy following stock market crashes and adverse events such as the Global Financial Crisis in 2008 and the COVID-19 pandemic. When inflation is increasing, however, then the Fed no longer has as much freedom to implement expansionary monetary policy, and when the Fed contracts its expansionary policies, this can decrease stock prices.

Inflation is also often accompanied by uncertainty, which can be bad for the stock market. Investors do not know how long it will last and do not know what to expect from monetary policy, meaning they might be less likely to invest in it.

In the near-term, investors will likely see higher returns on stocks in times of inflation, Veldkamp said, driven by prices increasing.

Goldstein warns, however, that, once inflation starts rising, the Fed will have “no choice but to increase rates abruptly.”

“And when this happens, this will tend to have a negative effect on the stock market,” he said.

What can the government do to reduce inflation?

The Federal Reserve will likely raise interest rates and ease the pandemic-era expansionary monetary policies that injected liquidity into financial markets, according to Goldstein, though he added that this is a “tough balance” as the economy still teeters toward a recovery.

“On the one hand, you want to provide stimulus to the economy and to markets to get over the crisis,” he said of the Fed. “But on the other hand, you don’t want to overdo it, so that things don’t overheat and cause inflation.”

Echoing Goldstein’s sentiments, Veldkamp told ABC News, “We’re probably going to see some interest rate rises.”

“So, if somebody hasn’t already refinanced their mortgage, now would be the time to do that,” she added. “We will probably see the Federal Reserve boost interest rates, because that’s their primary tool to constrain inflation, and what that does is it encourages people to save their money.”

But Goldstein warns that “the government cannot do a whole lot” when it comes to inflation.

Policies that have been tried in the past around the world, such as instituting price caps, can quickly backfire, Goldstein said, because they can bring about a whole new set of issues when the government intervenes like that in the economy.

In the short-term, anything the Biden administration — which operates independently of the Fed — can do to help ease the supply-chain bottlenecks will also help with keeping prices of goods down.

Veldkamp said that less government spending is the “traditional remedy to bring down inflation,” though adds that is not what we’re seeing happening at the moment with Biden’s proposed $1 trillion infrastructure bill.

This bill can help reduce inflationary pressures, however, “if that infrastructure helps to reduce the cost of doing business,” Veldkamp added.

“If fixing the potholes means that fewer delivery trucks are blowing out tires and things get to where they need to go on time — things run more smoothly,” she added. “If they can reduce the cost of doing business, they can bring down inflation.”

How can people protect themselves from the impacts of inflation?

“When you are dealing with inflation, you have to think about how you protect your investments,” Goldstein said. Just keeping money in your bank account could hurt, he said, “because you’re not getting compensated for the inflation.”

Some people choose to invest in the stock market, but as Goldstein mentioned, the stock market can be a bit of a mixed bag “because there could be overall macroeconomic implications that will push the stock market as a whole down.”

Veldkamp said her advice for Americans is: “Don’t leave your money in cash.”

“The value of cash is going to get eroded,” she said. “You want to look for, at the very least, a savings account that offers some interest. You might want to ask about money market mutual funds, those are financial products that are usually really safe, but give you a little bit more interest.”

“Things are getting more expensive, but if you protect the money that you have by putting it in interest-bearing accounts, you should do just fine, because your money will grow even faster than the price level is growing,” Veldkamp added.

“On the flip side, anybody who’s got a mortgage should be loving inflation,” Veldkamp said “If you owe somebody something, then inflation is eating away at the value of that debt, it should get easier and easier to pay back that loan.”

Will the inflation we’re seeing now be temporary?

In short, only time will tell.

In past months, policymakers including Fed Chair Jerome Powell have stressed that the inflationary pressures are expected to be “transitory” in the wake of the pandemic.

In a press conference earlier this month, however, Powell said that “supply constraints have been larger and longer lasting than anticipated.”

Powell said that “the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, specifically the effects on supply and demand from the shutdown, the uneven reopening and the ongoing effects of the virus itself” and stressed that the Fed’s tools “cannot ease supply constraints.”

Still, Powell said that he believes “our dynamic economy will adjust to the supply and demand imbalances, and that as it does, inflation will decline.”

“Of course, it is very difficult to predict the persistence of supply constraints or their effects on inflation,” Powell said. “Global supply chains are complex; they will return to normal function, but the timing of that is highly uncertain.”

Goldman Sachs economists, in their research note warning inflation will get worse before it gets better, said their core view remains that the underlying supply-demand imbalances will work themselves out as Powell has said.

“But it is now clear that this process will take longer than initially expected, and the inflation overshoot will likely get worse before it gets better,” the researchers warned.

The Goldman Sachs team said they expect the process of supply chain disruptions easing, inventories being rebuilt and the lingering impacts of pandemic-era fiscal boosts fading to “start by the second half of next year and to extend into 2023.”

Veldkamp told ABC News that she is only “modestly” concerned about inflation spiraling out of control like what was seen in the 70s.

“I do think it’s a possibility, I’m watching out for it,” she said. “At the same time, I think our central bankers know a lot more about how to contain inflation than they did in the 1970s. Economics has evolved a lot since then, and so I have confidence in the professionals running our monetary system, that they’re going to work hard to promote that.”

Goldstein echoed Veldkamp’s sentiments, saying that he doesn’t think the “nightmare scenario” of what happened in the ’70s is a likely outcome at this point.

“A lot has been learned from the past and how to deal with those situations,” he said. “And I think the Fed is ready to act, and if they see it is getting to that point, they can very quickly raise rates, and I think that will likely help.”

Copyright © 2021, ABC Audio. All rights reserved.

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