*I warned you after Labor Day that The Mathematician was going to be writing another guest post. I just can’t keep him away now that he’s had a taste of fame. With all the discussion around inflation these days, I thought it would be a great opportunity to throw him a bone and bring him back for an encore. What is inflation? Why do I care? How does it impact housing?*

*The Mathematician is going to review the basics around this complex topic today, and then return in a few weeks (after our brains have recovered) and help us understand how inflation impacts the housing market. As always, I’m keeping a running commentary (in pink!) and stuffing this article full of GIFs to keep you entertained.*

*Without further adieu, I give you THE MATHEMATICIAN! *

## Welcome to Inflation 101

It has been quite a while since I had a chance to talk with all you wonderful readers, and I am excited to be back to discuss a topic which has been in the news quite a lot lately: inflation.

In my previous post, we discussed how interest is a singularly powerful mechanism for accumulating wealth: fixed interest on mortgages guarantees extremely low payments for your future self! (*Dabs: I called this concept out as a future discount – we all love a good coupon code.*)

How can the payments in the future be lower if they are “fixed” for the duration of your thirty-year mortgage? Well, your mortgage payment itself will not lower in the dollar amount. Rather, the dollar amount will be a smaller cost relative to the other goods and services that you purchase in the future. Why does this happen? Inflation.

## The Force has Two Sides

Inflation is a force which acts in a similar mathematical way to our old friend “interest”. If you invest money and earn 2% effective annual interest, then $100 today will be $102 at the end of the year. Great! You made $2 for parking your money into a bank account, so you *should* have more spending power in the future.

Here comes the catch: every year we should expect the prices of consumer goods to increase by around 2%. This is the target inflation rate that is set by the Federal Reserve. The average inflation has hovered around this number for the last twenty years. (*Dabs: Uh, until the year which shall not be named*).

If we can expect a 2% increase in inflation every year, then this force is *discounting* the value of your savings and counteracting any interest you earn in a bank account or return you make on an investment portfolio. (*Dabs: Hang in there, guys. He’s about to give us a real world example.*)

## A Future Purchase

Let’s think about how this works. Say you want to buy a television a year from now. The television you want to buy costs $200 today. If inflation grows at 2% uniformly across the market, then next year the same television will cost $204. If you stuff $200 into your mattress and it earned no interest, then you would be $4 short of buying the television a year from now.

You can only afford 98% of the television with that “mattress” bank account. So, mattress bank accounts only work if your currency is vintage Harry Potter LEGO sets (yeah, I have done more work studying interest rates on LEGO sets than I have on mortgage rates).

If you invest your $200 in a bank which pays 2% annual effective interest, you will have $204 to buy that television which will cost 2% more in the future; this is a perfect balance. (*Dabs: The only reason this is perfect is because it’s a hypothetical he made up.*)

If the Fed misses the mark and the inflation rate grows at 3%, then your 2% bank interest rate wouldn’t cut it. You could have also invested your $200 in a ritzy investment fund which has a return of 10%! After a management fee (usually around 1%) and capital gains tax (currently 15%), you still might not have enough to cover the TV. There are forces that work for you (like interest) and forces that work against you (like inflation). (*Dabs: I am still stuck on understanding who is planning to buy their TV a year in advance.*)

How do they balance? Here is where inflation will really upset people: inflation makes you divide decimals! Here comes the math!

## The Mathematics of It All

If the annual effective interest that you earn on your savings is *i, *then your initial principle of *P *will become *P(1+i) *after one year. We multiply our principal by a number larger than one, making it larger. If the target rate of inflation is *j, *then we *divide P(1+i) *by *(1+j) *to arrive at the inflation adjusted effective rate of interest equation

In our example with the television, 2% effective annual interest with an on-target 2% uniform rate of inflation means that your inflation adjusted interest rate is 0%. (*Dabs: Guys, this is a super complicated way to say the two factors balanced each other out.*)

Of course, the price of some goods may grow at a faster rate – the price of chicken rose 13% last year. The price of others may be more volatile – ones that fluctuate a lot, like gasoline. Consequently, if the proportion of your household’s budget spent on goods or services which have risen in price more steeply than the aggregate target, your family will have a much lower adjusted rate of interest on savings.

## And Now the Acronyms

There are different inflation rates that include or exclude certain classes of goods. The most standard measure of inflation is the consumer price index or CPI. The CPI is the ratio of the current price of a “basket of goods” to a previous price of the same collection (then scaled by 100). (*Dabs: They basically load a fictitious shopping cart with goods, and then see how much it costs the next month to compare.*)

The single largest weighted item in the CPI is “shelter.” In this context, shelter is the service that your home provides you. It is measured by estimating how much rent you would pay to live in your home. When there is an increase in the price of homes or the price of rents, there is a large effect on inflation. (*Dabs: Makes sense, your shelter costs are usually a big chunk of your monthly budget.*)

That is the basic groundwork of the idea of inflation, but how does it happen and can it be tempered? I will mention yet again, I am not an economist: I only play one on my wife’s blog.

## Factors at Play

That being said, the cost of a good will rise when there is not enough supply, too much demand, or a combination of both of those forces. Supply chain issues have the effect of limiting the supply of goods. Stimulus payments have the effect of raising demand (more money in your pocket allows you to buy more).

These are only two examples of situations (in these cases both COVID-related) that lead to upward pressure on prices. The Fed can’t improve supply chain flows, but they can raise interest rates and make it harder to borrow money. When money is harder to get, demand will go down and one part of the inflation equation will yield downward pressure on prices. (*Dabs: No money, no buyers, no demand, lower prices.*)

As the Fed raises rates (seemingly at every meeting), it will help reduce inflation. At the same time, this will push up mortgage rates. This will make the decision to buy or sell a house tricky. Thankfully, we are in good hands with Dabs!

*Thanks for joining us this week! The Mathematician will rejoin us in a few weeks to discuss inflation as it relates to the housing market specifically. I like to change up the topics to keep the reading interesting. As always, I’m here to help with all your homeowner goals, questions and concerns!*

## This Post Has 2 Comments

That’s my smart godson! 😉

He is a smartie. We may be biased!