“If inflation has decreased over the last few years, why haven’t my expenses?”

We are often asked this question, whether in meetings with clients, out with friends, or perusing social media. Inflation is an important concept for people to understand, especially since the impact can be very personal.

What is Inflation and How is it Calculated?

Inflation is defined as the upward change in the price of a basket of goods or services over time. The rate of inflation measures the overall health of the economy.  The most common measure of inflation is the Consumer Price Index, more commonly referred to by its acronym, CPI.  The Bureau of Labor and Statistics calculates the CPI and includes the price of food, housing, energy, transportation, and medical care, among other basic expenses. CPI does not include interest costs, finance charges, or items produced in the home. CPI is different from the Core Inflation metric, which excludes more volatile price components, such as energy and food.

The inflation rate is calculated as:

(Current CPI – Prior CPI) / Prior CPI X 100 = Inflation Rate

From a historical perspective, CPI has ranged between 2 – 4% over the last 100 years, with the Federal Reserve currently targeting 2%. The average annual inflation rate for the last five years has been as follows:

• 2020 1.2%
• 2021 4.7%
• 2022 8.3%
• 2023 4.1%
• 2024 (YTD) 2.4%
• 2024 (Projected) 3.2%

Inflation spiked as high as 18% in 1946 after the war, 12.3% in 1974 after the Watergate Scandal, and 13% in 1979 and 1980 before the recession. The most recent inflationary period, which reached a peak of 10.1% in December 2022, came after COVID-19 and was attributed to a multitude of factors, including supply chain issues from COVID-19, increased money supply, and increased energy costs.

 What is Happening Now?

We have all felt the impact of inflation over the past few years, and we do not like it.  We have recently heard how inflation has decreased since its peak in December 2022.  We have heard it – but we are not feeling it, which is more important.  Why is that?

It’s simple: Although the rate of inflation has decreased from 10.1% to the projected 3.2% in 2024, prices are still inflating at a projected rate of 3.2%. Remember, inflation is the “upward” change in prices. We are experiencing disinflation, where the rate of inflation, or the rate of the increase in prices, is decreasing, but prices are still increasing. 

Disinflation is good for the economy because it helps people and businesses grow by increasing their purchasing power.

What people thought they were getting when they heard the rate of inflation was decreasing was a drop in the price of goods or services, which is known as deflation. Deflation is typically a sign of contraction in the money supply in the economy. Although dropping the price of goods or services sounds like a good thing, it can damage the economy and lead to lower economic growth and higher unemployment, and eventually to a recession if not acted upon timely. Deflation happened between 1930 and 1935 during the Great Depression, and again in 2008 and 2009 during the Great Recession. Disinflation is typically preferable to deflation. 

The interrelation between inflation, disinflation, and deflation and their economic impact can be complicated. Disinflation can feel emotionally as bad as inflation.

Navigating the Perception Gap

Understanding the nuances between inflation, disinflation, and deflation is essential for managing expectations in today’s economic climate. While inflation has slowed, disinflation does not equate to falling prices—only a reduction in the pace at which they rise. This distinction is often lost in translation, leading to the perception that relief isn’t materializing in household budgets.

For individuals, this means that expenses will continue to feel high because they are building on an already elevated price base. For policymakers, striking a balance between combating inflation and avoiding deflation remains a critical challenge.

As we move forward, maintaining an informed perspective can help mitigate frustration and empower more strategic financial planning. Whether through adjusting personal budgets, reevaluating savings strategies, or understanding how macroeconomic trends impact individual finances, staying educated about these economic forces is a vital step toward financial resilience.