Inflation is good when it is mild. There are two situations where this occurs. The first is when inflation makes consumers expect prices to continue rising. When prices are going up, people will buy now rather than pay more later. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. It creates a virtuous cycle, boosting economic growth.
The second is when it removes the risk of deflation. That’s when prices fall. People wait to see if prices will drop more before buying. It cuts back demand, and businesses reduce their inventory. As a result, factories produce less and lay off workers. Unemployment rises, leading to wage deflation. Now people have less money to spend, which reduces demand even more. Businesses lower their prices. That makes deflation worse. For this reason, deflation is even more corrosive to economic growth than inflation. The prices fell 10 percent during the worldwide Great Depression.
Examples
The housing industry provides an example of both inflation and deflation. Until 2006, gradually rising prices attracted investors. They saw there was a chance to make money by buying now and selling later. This created more jobs as home builders tried to meet demand.
But between 2006 and 2010, the housing market experienced massive deflation.
Prices fell 30 percent. Those who could afford to buy a house decided to wait until the market improved. The longer they waited, the lower prices dropped.
Many people were trapped in their homes. They could not sell their homes for enough to cover the mortgages. They became upside-down. Eventually, they could not see any light at the end of the tunnel.
Even those who could afford to keep paying, often just walked away. This sent prices even lower.
Others were counting on being able to sell their home in a year or so. They were counting on this to cover a mortgage they could not really afford. They foreclosed and lost their home when they were unable to cover their loan. This happened to so many people that there was a glut on the market. This shadow inventory was not really absorbed until 2013.
Those who kept paying their loans had less money to spend on other things. This drove down demand in other sections of the economy. What did they get in return? An ever-deflating asset.
How the Fed Keeps Inflation Healthy
Former Federal Reserve Chairman Ben Bernanke set an official 2 percent inflation target. The nation's central bank changes interest rates to keep inflation at around 2 percent. That is for the core inflation rate. It strips out volatile gas and food prices. It is also the year-over-year rate, not the month-to-month rate.
Inflation targeting sets people's expectations about inflation. They believe the Fed will make sure prices keep rising. That spurs them to shop now before prices rise even more. The Fed will lower interest rates to boost lending, if inflation does not reach its target.
The Fed will raise interest rates if inflation exceeds the Fed's target. Inflation targeting has become an critical component of monetary policy.
When Inflation Is Bad
If inflation is greater than 2 percent, it becomes dangerous. Walking inflation is when prices rise 3 percent to 10 percent in a year. It can drive too much economic growth. At that level, inflation robs you of your hard-earned dollars. The prices of things you buy every day rise faster than wages. Thanks to walking inflation, it takes $24 today to buy what $1 did in 1913.
Galloping inflation occurred during the 1980s. It prompted President Ronald Reagan to famously say, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man." It took double-digit interest rates and a recession to stop galloping inflation.
Thankfully, it hasn’t returned since then. The worst types of inflation are hyperinflation and stagflation.
One reason inflation hasn’t returned is that the Federal Reserve understands the four causes of inflation much better. It can more quickly put the brakes on rising prices by raising interest rates
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