Inflation is the rise in the prices of goods and services. When goods and services become more expensive, it translates into less purchasing power for consumers. Inflation is typically measured by comparing current prices to previous ones, and is usually expressed as a percentage increase or decrease, such as a 5% rise in inflation. The most commonly used measurement of inflation is the Bureau of Labor Statistics’ consumer price index (CPI), which tracks the average price change of a basket of goods and services over time.
Key Takeaways
- Inflation measures the increased cost of goods and services over a period of time.
- With inflation, prices rise, which can put a strain on many consumers’ budgets.
- The effects of inflation mean you have to decrease spending to keep up with price increases.
- This may make you reconsider your investment strategy and change your day-to-day financial habits.
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Definition of Inflation
Inflation reflects the increased cost of living over a period of time. It can be seen in rising expenses across a broad swath of consumer products and services, including these:
- Food
- Fuel
- Housing
- Utilities
- Health care
- Entertainment
- Transportation
What Is a Good Inflation Rate?
As prices increase, purchasing power decreases. This means your money buys fewer goods and services, and your cost of living goes up. Consistent rising inflation affects a country’s economic growth and has negative impacts for most people’s standard of living.
However, a small amount of inflation is considered a sign of a healthy economy. The Federal Reserve, which sets U.S. monetary policy, generally tries to keep inflation around 2% over time. When inflation is at or close to this mark, policymakers consider this the sweet spot for price stability and low unemployment. This can make it easier for consumers to make good financial decisions.
What Causes Inflation?
Inflation typically results from a mix of macro- and microeconomic factors. There are a few scenarios that can contribute to an inflationary economy:
Demand Factor
When consumer demand rises unexpectedly and the supply isn’t large enough to meet that demand, prices typically go up. For example, the price of eggs was significantly higher in 2022 and 2023 than in previous years, and your supermarket shelves may have had a limited number of cartons for sale. That was a result of the egg supply plummeting in 2022 after the U.S. experienced its worst outbreak ever of avian flu.
Supply Shocks
When a good or service suddenly becomes scarce and there isn’t a good substitute, it can cause a shock to the supply system and have a powerful impact on prices. This can be seen in the form of rapidly rising fuel prices in 2022 and 2023. This supply shock was at least partly a result of Russia’s invasion of Ukraine in 2022. Since Russia is one of the world’s top oil producers, there was global concern that there would be a squeeze on the supply of fuel without Russian exports.
Monetary Policy
Economists from the U.S. central bank, the Federal Reserve, may take actions to control the nation’s money supply to either stimulate economic growth during a period of slow or little growth (sometimes called stagflation) or rein in rapid inflation.
To try to control inflation, the Fed will either raise or decrease interest rates or change the requirements for how much money banks must keep in their reserves. These actions typically have their intended effect, but it’s often a slow process involving several incremental changes over time.
Types of Inflation
Inflation doesn’t just happen on its own. There are several types of inflation, each driven by different economic circ*mstances. The three most common types of inflation are demand-pull, cost-push and built-in. We’ll explain how each works below.
Demand-pull inflation occurs when the demand for something increases faster than the supply and the price subsequently rises to reflect that scarcity. People will often pay above the market value for an item when the demand is high and the available inventory is low.
In other words, the demand “pulls” the prices higher. Examples of this can be seen on a much smaller scale with items like a new video-game console or a toy that’s heavily marketed around the holiday shopping season when demand outstrips supply.
With cost-push inflation, the cost of raw materials needed to produce an item rises, leading to rising prices for all goods that rely on that product. For example, if a particularly dry season leads to a poor grain harvest, the cost of grain will go up, so bakeries’ production costs for bread will increase. Supermarkets and restaurants will then have to pay more for their bread, and in turn, they’ll charge customers more to make up for that price difference.
Consumer perception is the driving force behind built-in inflation. When the rate of inflation remains high for a period of time, people expect that it will continue to do so. This can lead to wage inflation, as workers will seek pay increases to keep up with an anticipated higher cost of living.
How To Measure Inflation
To assess if inflation is too high, too low or on track, American economists and policymakers typically rely on several indexes that are updated monthly: the consumer price index (CPI), the producer price index (PPI) and the personal consumption expenditures price index (PCEPI).
The CPI is the most commonly used inflation metric. It’s measured using data gathered monthly by the U.S. Bureau of Labor Statistics, which tracks price changes across a basket of about 80,000 everyday consumer goods and services ranging from groceries to gasoline to health care and utilities.
The PPI measures inflation from the perspective of the seller. It tracks monthly changes in more than 100,000 prices from about 25,000 establishments that voluntarily report data to the BLS. The PPI is the counterpoint to the CPI, allowing economists to compare price changes for consumers versus sellers.
The PCEPI is used by the Bureau of Economic Analysis to measure the relationship between changing consumer prices and changes in personal income. This is similar to the CPI but not the same. Although the PCEPI also tracks price changes across thousands of goods and services, it also compares those prices to how consumer spending behavior changes.
The PCEPI is often used to help forecast economic trends, and the Fed frequently uses it when creating monetary policy.
To measure the rate of inflation, you’ll need to decide your start date, your end date and the CPI value for each of those dates. The formula for inflation is:
Percent Inflation Rate = (Final CPI Index Value ÷ Initial CPI Value) x 100
Impact of Inflation on Consumers
Inflation affects people on a daily basis. When going to grocery stores, doctor’s appointments, movie theaters or shopping malls when inflation is high, consumers may feel the pinch nearly everywhere they spend.
In an inflationary economy, many households will have to make adjustments to their budgets. This can include eating cheaper meals at home (like buying chicken instead of beef), spending far less on non-essential items and turning the heat down when it’s cold and putting an extra layer of clothing on.
Few are immune to the effects of high inflation. Those living paycheck-to-paycheck in particular are most likely to feel the strain of higher prices. They may be forced to cut back on discretionary spending to meet their essential needs.
How To Deal With Inflation
A financial strategy to help combat the rising cost of living during inflationary times is to generate more income with the money you have. Investing in assets that typically outpace inflation can help you ride out tougher times.
Some financial products invest in a basket of securities paying high dividends or interest. These can include:
- Fixed-income funds
- Treasury bills
- Tax-free municipal bonds
- Exchange-traded funds
- Mutual funds
Buying real estate is another common way to invest your assets outside of the stock market. Your goal should be to diversify your portfolio to help minimize financial risk during an economic downturn.
How Does Inflation Impact Businesses?
Inflation doesn’t just impact consumers. Rising prices and costs can have a significant impact on businesses and investments, too. If a business has to pay more for raw materials or to package and ship its products, then the business’s profit margins will be reduced unless it raises prices. If the company raises prices during a time of inflation, its sales could go down.
Depending on the business, inflation can sometimes be a good thing for that business. An example of this is the auto industry during the COVID-19 pandemic. Supply-chain constraints caused prices for auto parts and vehicles to soar in the new-, used- and rental-car markets. Companies that sold or rented cars were able to capitalize on demand by increasing their prices when the supply was reduced.
When inflation is too high, businesses must adapt to find ways to offer the same products and services without passing their increased costs on to the consumer. Otherwise, they risk losing customers and decreasing their revenue even further.
In tough economic times, one investment strategy is to focus on companies that produce or sell essential household goods or provide essential services.
Example
It’s unlikely people will stop using energy entirely during the winter, as homes in colder climates require at least a moderate amount of heating. But people may not shop for new winter clothes when their budgets are strained.
FAQ: Inflation
Inflation reflects the increased cost of living over a period of time. Rising prices across a broad swath of consumer products and services, such as housing, fuel, food and utilities, are examples of inflation’s effect.
While inflation has slowed in the past two years, it is still high for a variety of reasons. A tight labor market continues to drive up wages, and supply chain disruptions and rising energy prices due to the war in Ukraine have kept inflation high, as well, according to a research paper from the National Bureau of Economic Research. Even with the inflation rate slowing, consumer prices remain high and public spending has not slowed, which in turn has caused the Fed to keep interest rates high.
Inflation, the rise in the general price level of goods and services in an economy over a period of time, can have various causes. Here are three main ones:
- Demand-Pull Inflation: This occurs when demand for goods and services exceeds their supply. When demand outstrips supply, producers often raise prices to maximize profits, leading to inflation. Factors that can contribute to demand-pull inflation include strong consumer confidence, low unemployment rates, expansionary fiscal or monetary policies, or rapid growth in money supply.
- Cost-Push Inflation: This type of inflation results from increases in production costs, such as wages, raw materials, or taxes. When businesses face higher costs, they may pass these expenses onto consumers in the form of higher prices, causing inflation. Factors contributing to cost-push inflation can include rising energy prices, increased import costs due to currency devaluation, or supply chain disruptions.
- Built-In Inflation: Also known as the wage-price spiral, this occurs when workers demand higher wages to keep up with rising prices, and employers pass these wage increases onto consumers through higher prices for goods and services. As a result, prices and wages chase each other in a never-ending cycle, leading to persistent inflationary pressures. Built-in inflation often arises from expectations of future inflation rather than current economic conditions.
These causes of inflation can sometimes overlap, and the interplay between them can vary depending on the specific circ*mstances of an economy. Central banks and policymakers closely monitor these factors to implement appropriate monetary and fiscal policies to control inflation and maintain price stability.
*Data accurate at time of publication
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
If you have feedback or questions about this article, please email the MarketWatch Guides team at [email protected].
