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Kimberly Amadeo

Inflation Not A Risk - Except to Your Christmas Dinner

By December 15, 2010

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Overall, prices are only 1.1% higher than last year, although food at home is 1.7% higher than a year ago. Higher food prices are due to a 7.7% increase in gas and oil prices, which are driving transportation costs up 2.9%. Lower clothing and natural gas costs are keeping inflation under control. (CPI). The Cleveland Fed is forecasting inflation to be under 2% for the next 10 years. (Source: BLS Consumer Price Index: December 15, 2010)

The core inflation rate is only .8%. Why is this important? A healthy, growing economy can sustain a core inflation rate of around 2%. Core inflation measures prices without volatile food and energy costs, which is why the Fed watches it more than the overall inflation index.

A core inflation rate of only .8% is bordering on deflation, which is when prices fall. Deflation is an ongoing symptom of a slow-growing economy. That's why the Fed launched QE2 last month, to add more money to the economy, spur inflation and create a faster growing economy.

What It Means to You

Rising food and oil prices feel more threatening than they really are. That's because you notice higher gas and grocery prices, because you shop for them each week, and the prices are very sensitive to supply. The prices can change in response to supply because the demand is inelastic. That means people need to buy gas and food, and can't really cut back on demand when prices rise.

Health care prices, on the other hand, don't affect you unless you are ill - and then they REALLY hit hard. That's because these are usually high-ticket items, especially if you need to go to the hospital and you don't have insurance. Health care prices having been increasing at around 3.5% for years.

Low prices for other things, like clothing and other consumer products, are a symptom of sluggish demand. What's keeping demand down? Lack of confidence in future income potential and wealth. People aren't out buying like they used to because they are either unemployed or afraid of losing their job. They've also lost a great deal of wealth in their home equity, savings and investments. They can wait to buy new clothes, or spend less, and so demand is elastic.

Until people regain confidence in the economy, prices will remain flat. The only exception to the rule is with stagflation. That could happen as the value of the dollar decline, which would raise the price of imports.

Your Opinion: Which Is the Bigger Concern - Inflation or Recession?

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