Inflation is dominating the news. While the price of everyday goods, including food and energy—naturally—grab the headlines, the ever-interesting Visual Capitalist reminds us of the other forms inflation within the economic system that impact our lives.
The first is monetary inflation, which occurs when the U.S. money supply increases over time. This represents both physical and digital money circulating in the economy including cash, checking accounts, and money market mutual funds. In the U.S. the Federal Reserve typically influences the money supply by printing money, buying bonds, or changing bank reserve requirements. The Fed controls the money supply in order to boost the economy or tame inflation and keep prices stable.
Nobel Laureate Milton Friedman once posited that "inflation is always and everywhere a monetary phenomenon." That's because, in theory at least, increasing the money supply faster than the growth in real output may cause consumer price inflation (# 2 below); more money chasing the same amount goods should eventually lead to increases in prices.
Next is consumer price inflation ("CPI"), which occurs when the prices of goods and services actually increase. It is typically measured by the Consumer Price Index (CPI), which shows the average price increase of a basket of goods, such as food, clothing, and housing. Supply chain issues, geopolitical events, monetary supply, and consumer demand may all affect CPI. When CPI is persistently increasing at rate above 2% per annum, the Fed may increase interest rates to curtail spending and allow prices to cool down, and vice versa.
Lastly, asset price inflation ("API") represents the price increase of stocks, bonds, real estate, and other financial assets over time. One measure of API is the ratio of household net worth to GDP. Often, a low interest rate climate creates a favorable environment for asset prices by lowering the total cost of asset ownership. This has been evident over the past decade as low rates were met with rising asset prices. In 2021, household net worth as a percentage of GDP stood at 620%. Rising asset prices can sometimes be a misleading sign of a strong economy since no real output is produced—the stock market is not the economy. Instead, it may indicate an asset bubble, which is dangerous because it contributes to rising inequality (as typically the very rich own the vast majority of economic assets). But when bubbles burst, the government has to step in with taxpayers' (i.e., everyone's) money to save the economy (and thereby the rich). The moral hazards in a laissez-faire capitalistic system can give rise to demagoguery.
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