an act of inflating or the condition of being inflated

–Webster

The CPI – One number to represent it all.

How does the government measure the inflation rate? They use the Consumer Price Index (CPI). The U.S. Bureau of Labor Statistics gathers a LOT of data about our economy. Their job is to collect, analyze and report on employment (or the lack thereof) and price statistics – the leading indicators for how well our economy is doing.

To calculate the CPI, they gather data from approximately 23,000 businesses and get prices on 83,000 items. Then, they roll prices on these items into categories and apply a weight. Yep, it’s your good old “weighted average”. If you wanted to, you could drill down to your state in their database and see how your state compares to other states on things like rent or the price of eggs. But I want to see the macro level – the 50,000 ft view of the United States as a whole.  Therefore, I grabbed their monthly and annual data for the US from 1913 forward.

Inflation rate – what does it mean?

Using that one weighted average from all those prices, we can calculate the percentage of change from one period to another. For example, the annual CPI for 2021 was 270.97. In 2022, the annual CPI was 292.655. The CPI increased by 8%, that’s the inflation rate. You can check this calculation using the following formula:

(Current period – Previous Period) / Previous Period

(292.655 – 270.97) / 270.97 = .080027 = 8%

That 8% tells us something interesting. If I purchased an item for $1 in 2021, that same item would cost $1.08 in 2022 … for the most part. Basically, I take my $1 and multiply it by 1.08 or 1 + the percentage.

Some items will be more, others will be less, but if you look at all my purchasing power in 2022 vs 2021, my purchasing power decreased by 8% in 2022.  That’s what the inflation rate is telling us.

Yea, I’m with you. Inflation BAD! I can’t buy as much as I did last year!? Well …. that’s only if my income stays the same as last year. What if my income grew by 10% Then I have more money in my pocket and the net (10 – 8) results in an increase of 2% purchasing power.

Let’s see this in a graph!

The following line graph shows the rise and fall of the inflation rate by year from 1913 to 2023. I highlighted some historical points on the chart such as WWI, the Great Depression, the 1960 and 1980 Recessions.

Students of history will look at the chart and be able to pick out what was happening to affect the inflation rate. While we could say the inflation rate change is complicated, we can usually look at it through the lens of supply and demand.

What makes prices go up?

You can remember the effect of supply and demand with two simple rules:

1. As demand for a product increases, the price of the product rises.
2. If the supply of the product decreases, the price of the product rises.

Therefore, when people have more money to spend, demand increases, thus prices increase. If people can’t access money, for example, interest rates increase, demand decreases and prices decrease.

If something happens, such as a pandemic or a war, and products are not available, prices increase. But when production of that product increases, the price will decrease.

How does the Federal Reserve manage inflation?

The Federal Reserve has been in the news a lot lately because they have been raising interest rates after the Covid pandemic. The Fed was founded in 1913 by Congress to stabilize the banking system. The Federal Reserve history is interesting, but I won’t go into it here. Suffice to say, if we think things are bad now, just be happy this isn’t mid 1800’s!

The Federal Reserve can manage inflation rate using three methods:

1. Interest rate changes
2. Reserve Requirements
3. Cash Supply

When we hear “The Federal Reserve increased interest rates”, the interest rate in question is the rate banks use to borrow money from the government. When banks have to pay more interest, they pass that on to their customers. Thus, it’s harder for consumers to get loans. Less money in the market means less spending and prices drop.

The Federal Reserve also tells the bank how much capital they need to keep on hand (how many greenbacks are in those vaults?). The more capital banks need to keep, the less they lend to consumers. Again, consumers have less cash to spend on products and prices drop.

The Federal Reserve is tasked with deciding how much money to print each year. They do a balancing act between printing and destroying currency notes. They keep track of the inventory of currency in circulation. The more cash in circulation, the more consumers can spend, prices rise.

WWI Effect on Inflation

In the above chart, I found the volatility of the CPI in the early years rather interesting. One theory bases the volatility on how the dollar is valued. But more likely, it was the increase of cash in the market. The US government poured money into the economy in support of WWI, prior to entering the war in 1917. Basically, instead of funding the war effort through taxes, we printed more money. US exports went from approx. $480M in 1913 to $1.6B in 1916. There was a demand for more products and more cash in circulation. People were buying and prices skyrocketed.

Then US entered the war. The inflation rate dropped a little bit with the shift, but we also saw the manufacturing sector rise with an increase in wages and in the US the unemployment rate dropped. WWI had a stabilizing effect on the prices.

Then the war ended. Factories began to ramp down. Job opportunities decreased. Returning soldiers added to the population looking for work. Without jobs, people didn’t have money to spend, the US slid from a recession to a depression in 1920-1921.

Recession? Depression?
Does the Economy need Prozac?

We pretty much get inflation – prices rise faster than we can afford. But what exactly is the difference between a recession and a depression? In the 1930s we got jokes like “Recession is simply the way Democrats spell depression.”  Both recession and depression are marked with drops in the CPI.

Recession is a downward trend. Household income decreases, spending decreases. People and businesses delay making large investments or purchases. Depression is more than a trend. Industrial production is sharply reduced, widespread unemployment, drops or complete cessation of construction. With a depression we’re not just talking about an increase of prices, but economic shut down.

As one 1930’s saying goes, Recession is when you tighten your belt, depression is when you don’t have a belt to tighten. If you notice in the chart above, we had two depressions in the early 1900’s and three recessions after 1950. We only have a vew times when the CPI went below the 0 mark. Since 1950, the CPI has been above the 0 mark. Recessions occur in response to sharply increasing inflation rates. When the inflation rate stays stable, prices may be increasing, but it’s not out of balance with other economic factors.

Effect of Interest Rate Changes with Covid-19

WWI was a hundred years ago. I doubt there are many of us who have a living memory of WWI. But most of us do remember 2020. Some of us remember the 1980s recession.

We hear a lot these days about the Federal Reserve increasing the interest rate like it’s a bad thing. But the Federal Reserve is increasing the interest rate to offset the increase in prices. Just for the fun of it, I decided to look at the comparison of the Inflation Rates to the Interest Rates from January 2020 to December 2023. In the chart below, I also added a couple of trend lines.

The red and blue bars are the inflation rate. Red is when Trump was in office and blue is when Biden is in office. As you can see the CPI decreased in April of 2020. We hit a mini recession during April and May of 2020. At the same time the Federal reserve began dropping the interest rate. The Federal Reserve was trying to make it easier for people to get loans. Even though most folks were trying to get back to a normal life by June or July, Covid was continuing to wreak havoc.

We didn’t really start to see the increase in CPI until around February or March of 2021. By this time, the interest rates had dropped to nearly 0%! The Federal Reserve didn’t increase the interest rate until about a year after the CPI had started rising. If you notice, the CPI hit its peak, around July 2022. It is also around this time we see a sharp increase in interest rates and prices dropping.

The polynomial trend lines cross around July of 2023 and it is about this time that we see both the inflation rate and interest rate flatten out as we move into 2024. I think this tells an interesting story about the interaction between inflation and interest, with a side lesson to not get too excited when you hear newscasters pulling one piece of data out and making it sound like the sky is falling!

Government Response to Economic Crisis

I know the Federal Reserve wasn’t the only government agency trying to stave off a recession. When the Biden administration took office, the inflation was beginning. Inflation does not happen overnight, although it may feel differently, inflation takes time to respond. Think of it as the sore throat and headache you experience 10 days after being infected with Covid. A week after that, you feel a lot worse.

The Federal Reserve did all it could to weaken the impact of Covid on the economy during 2020. Not disputing the economy under Trump before Covid 19 (that’s a topic for another post), but after Covid-19 is a different story. March 27, 2020 Trump signed the largest economic stimulus package in US History, the Coronavirus Aid, Relief, and Economic Security Act (CARES). This act included:

• $300B cash payments to people who submitted a tax return.
• $260B increased unemployment benefits.
• $350B to small businesses
• $500B to corporations
• $340B to state and local governments

The Biden Administration did its part to stabilize the economy, such as:

• Expanding unemployment insurance benefits and enhancing the child tax credit, resulting if more money in the pockets of consumers so they would be able to continue to purchase essentials.
• Expanding operations at the ports of Los Angeles and Long Beach to ease supply chain bottlenecks to keep prices down.
• Releasing more than 180 million barrels of oil from the Strategic Petroleum reserve to help reduce gas prices.
• Passed the Inflation Reduction act to lower out of pocket costs of prescription drugs, especially for seniors on Medicare.
• Passed the infrastructure Investment and Jobs Act and the CHIPS and Science Act to invigorate production in the private sector.

Biden’s administration inherited the pandemic “recession” that could have led to a depression. Three years later we are seeing a stabilizing growing economy. We may still be feeling the pinch of the inflation correction, but the trends are looking good – at least in my opinion.

References and Disclaimer

Just to set the record straight — I am not an economist. I’m simply a person trying to understand a complex problem so I can make an informed decision when it comes time to vote in the 2024 elections. The following are some of the web sites I used to get my information.

https://www.stlouisfed.org/publications/regional-economist/second-quarter-2017/a-short-history-of-prices-inflation-since-founding-of-us
https://www.history.com/news/pandemic-world-war-i-roaring-twenties
https://www.investopedia.com/ask/answers/042015/how-does-money-supply-affect-inflation.asp
https://www.investopedia.com/ask/answers/042015/how-does-money-supply-affect-inflation.asp
https://www.federalreservehistory.org/essays/federal-reserve-history
https://www.macrotrends.net/2015/fed-funds-rate-historical-chart
https://www.whitehouse.gov/omb/briefing-room/2022/03/28/president-bidens-economic-strategy-and-fiscal-responsibility-decreasing-deficit-by-more-than-1-3-trillion-largest-one-year-decline-in-u-s-history/
https://www.americanprogress.org/article/the-top-5-actions-the-biden-administration-has-taken-to-strengthen-the-u-s-economy/
https://www.washingtonpost.com/graphics/2020/politics/trump-covid-pandemic-dark-winter/
https://www.factcheck.org/2020/10/timeline-of-trumps-covid-19-comments/