Dan Passarelli, CEO - Market Taker Mentoring

The CPI number was released this morning at 8.6, the highest since 1981, really much hotter an inflation figure than many people were expecting.

Let’s take just a minute to explain what inflation is, and what some of the challenging things in fighting it are and just what implications this can have for us.

To illustrate, I was talking with a friend of mine who's not a financial person at all, and she was asking, what is inflation? I said, that's when prices go up. And she's like: what do you mean?

And so, to explain, just imagine that if you wanted to buy a small house for $100,000, let's just say nice round number, and that house is for sale for $100,000 right now. And you happen to have that in the bank. Well, you could just go and buy that house right now. But if you waited a year, that $100,000 wouldn't be able to buy that house. If all prices across the board rose by 8.6%, that house would be worth $108,600, and you wouldn't have enough money.

Or let’s say you budget your groceries at $100 a week. On January 1, you put $5,200 in the grocery savings account in your bank and the plan is to spend only $100 a week. You wouldn't be able to buy as much as the year goes on because the prices of those groceries would get more expensive, the $5,200 would run out, and you'd be hungry the last month or so of the year.

So that's what it is in a nutshell, just to kind of break it down. The Federal Reserve tries to fight that because that can promote lots of different problems. And what they do is they raise rates to try and prevent that.

Now, before we even get into exactly why that is and how that works: Let’s talk about some of the challenges that come along with a high inflation number. It actually can kind of turn out to become a little bit of a self-fulfilling prophecy that can spiral and can get really difficult to fight because Social Security checks are indexed based on inflation. And so those checks are going to be bigger, pumping more money into the economy.

The interest rates of I-bonds are attached to the inflation rate. Those are going to be bigger payments, pumping more money into the economy.

Those figures affect everything! I'm currently in the process of trying to hire somebody and in wage negotiations, people say, hey, no, I can't work for that amount because inflation is higher. So it's going to have to be higher wages.

Once it gets out of control, it becomes really hard to get back into control. I mentioned before that the Fed’s tool for fighting this is raising interest rates. Here's the thing: if you think of it from the fact that the more money someone makes, the more money someone spends because that's kind of part of the problem.

The more money that things cost, they have to pay more and so they get higher wages and then they spend more. When they raise interest rates, they're doing two things at once. They're basically making it more expensive to borrow money so that maybe people choose not to buy some of these more expensive items. And what that does, in effect, is: cooling down the economy.

Cooling down the economy, (slowing down the economy) is actually the tool for fighting inflation.

That becomes a pretty tricky dance. Do we slow down the economy just enough, the exact perfect amount, just to bring inflation under control and everything works perfectly??...

Or is there too much of a fudge factor and eventually slow it down too much: that can put us into a recession or worse yet: if the inflation is just too far out of control, (does raising interest rates put us into a recession??) and we still have inflation which is a situation called Stagflation which is the worst case scenario of the scenarios out there.

Hopefully, this overview helped to give a deeper understanding of how this all works. And why it's such a big deal. And why the fed looks at numbers like CPI and PPI and some of the other numbers that they look at as well.

Like PCE, for example, that's their preferred inflation gauge so I hope that helps.