Inflation is healthy for the economy – but too much can trigger a recession

In a healthy economy, prices tend to go up – a process called inflation.

While you might not like that as a consumer, moderate price growth is a sign of a healthy, growing economy. And, historically at least, wages tend to go up at about the same pace during periods of inflation.

The U.S. Federal Reserve sees 2% inflation as the sweet spot for the economy, which is about its current level. But some economists, including those at the Fed, worry the economy is weakening, which would cause inflation to drop below its target – something it wants to avoid. The latest data, out June 12, suggested this may be happening.

As a result, there’s growing speculation that the Fed will cut interest rates to give the economy a boost, which would indirectly spur more inflation. The problem is, too much inflation can also be a bad thing.

I’ve been studying how inflation affects markets for many years. Let me explain what it is – and why the Fed has a tough job ahead.

Better, worse, the same? Reuters/Joshua Roberts

What is inflation?

Inflation is defined as the rate of change in the prices of everything from a bar of Ivory soap to the cost of an eye exam.

In the U.S., the most commonly used measure of inflation is based on something called the consumer price index. Simply put, the index is the average price of a basket of goods and services that households typically purchase. It’s often used to determine pay raises or to adjust benefits for retirees. The year-over-year change is what we call the inflation rate.

The current change in the index is around 2%. But this is an average across a range of categories. For example, over the last year, the price of tobacco products went up 4.6%, while the pricing of apparel actually fell 3%. Clearly, the actual change in cost of living will vary from person to person depending on how they spend their money.

The latest data from the Department of Labor showed a closely watched measure of inflation was lower than expected in May, a worrying sign that the economy may be growing too slowly.

A moderate amount of inflation is generally considered to be a sign of a healthy economy, because as the economy grows, demand for stuff increases. This increase in demand pushes prices a little higher as suppliers try to create more of the thing that consumers and businesses want to buy. Workers benefit because this economic growth drives an increase in demand for labor, and as a result, wages usually increase.

Finally, these workers with higher wages go out and buy more stuff, and so this “virtuous” cycle continues. Inflation isn’t really causing all this to happen – it is merely the symptom of a healthy, growing economy.

But when inflation is too low – or too high – a “vicious” cycle can take its place.