What is inflation and what does it mean?
People have always grumbled that a dollar doesn’t go as far as it used to. But these days, that complaint is truer than ever. No matter where you go — the gas station, the grocery store, the movies — prices are higher than they were just a month or two ago.
What we’re seeing is the return of a familiar economic foe: inflation. Many Americans alive today have never seen price increases like these before. For the past three decades, inflation has never been above 4% per year. But as of March 2022, it’s at 8.5%, a level not seen since 1981.
Modest inflation, like what we had up through 2020, is normal and even healthy for an economy. But the rate of inflation we’re seeing now is neither normal nor healthy. It does more than just raise the cost of living. It can have a serious impact on the economy as a whole.
Recent inflation-related news:
- In March 2022, the U.S. inflation rate hit a 40-year high of 8.5%.
- Prices for gasoline have increased nearly 50% over the past year.
- Retail giant Amazon has added a 5% fuel and inflation surcharge for sellers.
- The Federal Reserve is planning a series of interest rate hikes to cool the overheated economy.
What Is Inflation?
Inflation is more than just rising prices. Prices of specific things we buy, from a gallon of milk to a year of college tuition, rise and fall all the time. These price increases affect individual consumers’ lives, but they don’t have a big impact on the entire economy.
Inflation is a general increase in the prices of goods and services across the board. It drives up prices for everything you buy, from a haircut to a gallon of gas. Or, to put it another way, the purchasing power of every dollar in your pocket declines.
Most of the time, inflation doesn’t disrupt people’s lives too much, because prices rise for labor as well. If your household spending increases by 5% but your paycheck increases by 5% at the same time, you’re no worse off than before.
But when prices rise sharply, wages can’t always keep up. That makes it harder for consumers to make ends meet. It also drives them to change their spending behaviors in ways that often make the problem worse.
Causes of Inflation
Inflation depends on the twin forces of supply and demand. Supply is the amount of a particular good or service that’s available. Demand is the amount of that particular good or service that people want to buy. More demand drives prices up, while more supply drives them down.
To see why, suppose you have 10 loaves of bread to sell. You have 10 buyers who want bread and are willing to pay $1 per loaf. So you can sell all 10 loaves at $1 each.
But if 10 more buyers suddenly enter the market, they will have to compete for your bread. To make sure they get some, they might be willing to pay as much as $2 per loaf. The higher demand has pushed the price up.
By contrast, if another seller shows up with 10 loaves of bread, the two of you will be competing for buyers. To sell your bread, you might have to lower the price to as little as $0.50 per loaf. The higher supply has pushed prices down.
Inflation results from demand outstripping supply. Economists often describe this as “too much money chasing too few goods.” There are several ways this kind of imbalance can happen.
Cost-push inflation happens when it costs more to produce goods. To go back to the bread example, cost-push inflation might happen because a wheat shortage makes flour more expensive. It costs you more to make each loaf of bread, so you can’t afford to bake as much.
As a result, you bring only five loaves to the market. But there are still 10 customers who want to buy bread, so they must pay more to get their share. The higher cost of production drives down the supply and thus drives up the price.
In the real world, cost-push inflation can result from higher costs for anything that goes into making a product. This includes:
- Raw Materials. The wheat that went into your bread is an example. Higher-cost wheat means higher-cost flour, which means higher-cost bread.
- Transportation. In today’s global economy, materials and finished goods move around a lot. Transporting products requires fuel, which usually comes from oil. So whenever oil prices go up, the price of other goods rises as well.
- Labor. Another factor in production cost is labor. When schools closed during the COVID-19 pandemic, many parents had to stop working to care for their children. That created a worker shortage that drove prices up.
The opposite of cost-push inflation is demand-pull inflation. It occurs when consumers want to buy more than the market can supply, driving prices up.
Typically, demand-pull inflation results from economic growth. Rising wages and lower levels of unemployment put more money in people’s pockets, and people who have more money want to spend more. If the booming economy hasn’t produced enough goods and services to match this new demand, prices rise.
Other causes of demand-pull inflation include:
- Increased Money Supply. Another way people can end up with more money in their pockets is because the government has put more money in circulation. Governments often do this to stimulate a weak economy or to pay off past debts. But as the money supply increases, the purchasing power of each dollar shrinks.
- Rapid Population Growth. When the population grows rapidly, the demand for goods and services grows also. If the economy doesn’t produce more to compensate, prices rise. In Europe during the 1500s and 1600s, prices soared as the population grew so fast that agriculture couldn’t keep up with the new demand.
- Panic Buying. Early in the COVID pandemic, consumers started buying extra groceries to fill their pantries in preparation for a lockdown. This led to shortages of many staple products, like milk and toilet paper. As a result, prices for those goods went up.
- Pent-Up Demand. This occurs when people return to spending after a period of going without. This often happens in the wake of a recession. It also occurred as pandemic restrictions eased and people returned to enjoying movies, travel, and restaurant meals.
When consumers expect prices to be higher in the future, they often respond by spending more now. If the purchasing power of their savings is only going to fall, it makes more sense to take that money out of the bank and use it on a major purchase, like a new car or a large appliance.
In this way, expectations of high inflation can themselves lead to inflation. This type of inflation is called built-in inflation because it builds on itself.
When workers expect the cost of living to rise, they demand higher wages. But then they have more to spend, so they spend more, driving prices up. This, in turn, reinforces the belief that prices will keep rising, leading to still higher wage demands. This cycle of rising wages and prices is called a wage-price spiral.
Effects of Inflation
Inflation does more than just drive up the cost of living. It changes the economy in a variety of ways — some harmful, others helpful. The effects of inflation include:
- Higher Wages. As prices rise with inflation, wages typically rise as well. This can create a wage-price spiral that drives inflation still higher.
- Higher Interest Rates. When the dollar is declining in value, banks often respond by raising interest rates on loans. The Federal Reserve also typically raises interest rates to cool the economy and rein in inflation, as discussed below.
- Cheaper Debt. Inflation is good for debtors because they can pay off their debts with cheaper dollars. This is most useful for loans with a fixed interest rate, such as fixed-rate mortgages and student loans.
- More Consumption. Inflation encourages consumers to spend money because they know it will be worth less later. All this spending keeps the economy humming, but it can also drive prices even higher.
- Lower Savings Rates. Just as inflation encourages spending, it discourages saving. Higher interest rates can counter this effect, but they often don’t rise enough to make a difference.
- Less Valuable Benefits. High inflation is worse for people on a fixed income. They face higher prices without higher wages to make up for them. Benefits such as Social Security change each year to adjust for inflation, but higher benefits next year don’t help when prices are rising right now.
- More Valuable Tangible Assets. Inflation reduces the purchasing power of the dollars you have in the bank. Tangible assets like real estate, however, gain in dollar value as prices rise.
The most common measure of inflation is the Consumer Price Index, or CPI. The Bureau of Labor Statistics (BLS) determines the CPI based on the cost of an imaginary basket of goods and services. BLS workers painstakingly check prices on all these items each month and record how each price changes.
To calculate the annual rate of inflation, the BLS looks at how much all prices in its basket have changed since a year earlier. Then it “weights” the value of each item based on how much of it people buy. The weighted average of all items becomes the CPI.
The BLS then uses the CPI to calculate the annual rate of inflation. It divides this month’s CPI by the CPI from a year ago, then multiplies the result by 100. This shows how the purchasing power of a dollar has changed over the last year. The result is reported monthly.
Other measures of inflation include:
- Personal Consumption Expenditures Price Index (PCE). This inflation measure is published by the Bureau of Economic Analysis. Like the CPI, it’s a measure of consumer costs, but it’s adjusted to account for changes in the products people buy. The Federal Reserve uses the PCE to guide its monetary policy, as discussed below.
- Producer Price Index (PPI). The PPI measures inflation from the seller’s perspective, not the buyer’s. It’s calculated by dividing the price sellers currently get for a basket of goods and services by its price in a base year, then multiplying the result by 100.
Historical Examples of Inflation
A little bit of inflation is normal. But sometimes inflation spirals out of control, with prices rising more than 50% per month. This is called hyperinflation, and it can be devastating for an economy.
Hyperinflation has occurred at various times and places throughout history. During the U.S. Civil War, both sides experienced soaring inflation. Other examples include Germany in the 1920s, Greece and Hungary after World War II, Yugoslavia and Peru in the 1990s, and Venezuela today. In most cases, the main cause was the government printing money to pay for debt.
The last time the U.S. had prolonged, high rates of inflation was in the 1970s and early 1980s. The inflation rate was nowhere near hyperinflation levels, but it spiked above 10% twice. Eventually, the Fed hiked interest rates to double-digit levels to get it under control.
Although high inflation can be destructive, zero inflation isn’t a good thing, either. At that point, an economy is at risk of the opposite problem, deflation.
When prices and wages fall across the board, consumers spend less. Sales of products and services fall, so companies cut back staff or go out of business. As a result, jobs are lost and spending drops still more, worsening the problem. The Great Depression was an example.
Monetary Policy Tools: How the Federal Reserve and Other Central Banks Fight Rising Prices
The Federal Reserve, or Fed, is the U.S. central bank — or more accurately, banks. It’s a group of 12 banks spread across the country under the control of a central board of governors. Its job is to keep the economy on track, reining in inflation while trying to avoid recessions.
The Fed maintains this balance through monetary policy, or controlling the availability of money.
Its main tool for doing this is interest rates. When the economy is weak, the Fed lowers the federal funds rate. This makes it easier for people to borrow and spend.
When the problem is inflation, it does the opposite, raising interest rates. This makes it more costly to borrow and more worthwhile to save. As a result, consumers spend less, slowing down the wage-price spiral.
The Fed has other tools for fighting inflation as well. One option is to change reserve requirements for banks, requiring them to hold more cash. That gives them less to lend out, which in turn reduces the amount consumers and businesses have to spend.
Finally, the Fed can reduce the money supply directly. The main way it does this is to increase the interest rate paid on government bonds. That encourages more people to buy bonds, which temporarily takes their money out of circulation and puts it in the hands of the government.
Inflation Frequently Asked Questions (FAQs)
If you keep seeing stories about inflation in the news, you may have some other questions about how it works. For instance, you may wonder:
What Is Hyperinflation?
Hyperinflation is more than just high inflation. It’s a wage-price spiral gone mad, sending prices soaring out of control. As noted above, the usual definition of hyperinflation is an inflation rate of at least 50% per month — more than 12,000% per year. However, some economists use the term to refer to an inflation rate of 1,000% or more per year.
What Is Disinflation?
Disinflation is a fall in the rate of inflation. This is what the Federal Reserve and other central banks try to achieve through their monetary policy, such as raising interest rates.
Disinflation is not the same as deflation, or falling prices. During a period of disinflation, prices are continuing to rise, but the rate at which they rise is slowing down.
What Is Transitory Inflation?
When the first signs of a post-COVID-19 inflation spike appeared, Federal Reserve chair Jerome Powell described it as “transitory.” By this, he meant that the rise in prices would be short-lived and would not do permanent damage to the economy.
However, in November 2021, Powell declared it was “time to retire that word.” Based on the growth in prices, he had concluded that inflation was more of a long-term trend. The Federal Reserve responded by planning to fight inflation harder, buying more bonds and plotting out a series of interest rate hikes.
What Is Core Inflation?
Measuring inflation can be tricky because prices for some products fluctuate more than others. Food and energy prices, in particular, can shift a lot from month to month. Including these products in the CPI can lead to sharp, but temporary, spikes or dips in the inflation rate.
To adjust for this, the CPI and PCE have a separate “core” version that doesn’t include food or energy prices. This core inflation measure is more useful for predicting long-term trends. The main versions of the CPI and PCE, known as the “headline” versions, give a more accurate picture of how prices are changing right now.
What Is the Consumer Price Index (CPI)?
As noted above, the Consumer Price Index, or CPI, is the main measure of inflation in the United States. The BLS calculates it based on how much prices have risen for an imaginary basket of goods and services that many Americans buy.
A little inflation in an economy is normal. It can even be a good thing, because it’s a sign that consumers are spending and businesses are earning. The Fed generally considers an annual inflation rate of 2% to be healthy.
However, higher inflation can cause serious problems for an economy. It’s bad for savers whose nest eggs, including retirement savings, shrink in value. It’s even worse for seniors and others on fixed incomes whose purchasing power has fallen. And it often requires strong measures from the central bank to correct it — measures that risk driving the economy into a recession.
If you’re concerned about the effects of inflation, there are several ways to protect yourself. You can adjust your household budget, putting more dollars into the categories where prices are rising fastest. You can stock up on household basics now, before the purchasing power of your dollars falls too much.
Finally, you can choose investments that do well during periods of inflation. Stock-based mutual funds and real estate investment trusts are both good choices. Just be careful with inflation hedges like gold and cryptocurrency, which carry risks of their own.