What is Inflation?

Guide for tips on managing inflation

What is Inflation?

At its simplest, inflation is the rise in prices over time that leads to a decrease in purchasing power of money. What it means in practice is that while a $10 bill could buy you a week’s worth of fast-food burgers in 1960, today it can barely buy you lunch.

No matter where you’re living or what your age or income level, inflation will have at least some impact on your finances:

  • Budgeting: Inflation throws a wrench into your budgeting plans. The same amount of money today won't buy you what it did yesterday.
  • Saving and Investing: Inflation eats into the value of your savings over time. If your savings interest rate doesn't keep pace with inflation, your money is losing buying power.
  • Debt Management: Fixed-rate debt (like a mortgage) can become easier to manage with moderate inflation, as your loan payment stays the same. However, high inflation can make variable-rate debt payments more burdensome as interest rates often rise with inflation—more on that later.

Understanding the Inflationary Landscape

So, how do we measure inflation? Economists track a range of various goods and services to calculate the average price increase over a specific period, usually a year. This measure, called the Consumer Price Index (CPI), takes into account everything from housing, to your morning orange juice, and the gasoline you put in your car. 

The result is expressed as a percentage, which is where the inflation rate comes from. For example, the average inflation since 1960 is somewhere around 3.7%, which makes for a total cumulative price change of about 948% – which is why that nickel candy bar now costs so much!

Here’s another way of looking at it. Parents giving their kids a $1 a week allowance in 1960 is the equivalent of giving your kids a dime a week today. Ouch!

A Closer Look at the Types of Inflation

There are different types of inflation forces at work, and they can act independently or play off others—often creating unexpected (and uncomfortable) results for the economy. That’s why economists and governments work so hard to regulate it. Let’s take a look at some of the different types of inflation and how they can interact.

Demand-Pull and Cost-Push: Tug of War in the Economy

The two major types of inflation are demand-pull and cost-push. Demand-pull inflation is when the demand for something is higher than the supply. The increased demand causes businesses (and savvy early buyers who resell the product online) to raise their prices.

Conversely, cost-push inflation occurs when production costs increase, which in turn are passed on to consumers through higher prices. Natural disasters, geopolitical upheavals, global pandemics, and anything else that disrupts the supply chain can act as catalysts for cost-push inflation.

Here’s an example: The cost of crude oil increases due to geopolitical factors elsewhere in the world. Gas prices go up, so the cost of transporting your eggs from the farm to the grocery store has now increased for the owner of the trucking company, who raises their prices to compensate. The grocery store now has to pay more to get the eggs to their shelves, so the price tag on the store shelf increases. Now you, the consumer, have to pay more for the same number of eggs because of seemingly unrelated events elsewhere in the world.

Built-In Inflation

Built-In inflation is also known as the wage-price spiral. It refers to inflation expectations that spill into both wage negotiations and pricing decisions. For example, if workers expect prices to rise by 3% next year, they might negotiate for a 3% raise to maintain their purchasing power. In turn, to cover the higher payroll costs, businesses raise prices on their goods and services.

Unchecked, these two forces can feed into each other as employees need higher wages to cover the higher costs of goods, and businesses charge higher prices to cover the higher wages—hence the term “wage-price spiral.”

Imported Inflation

In a global economy, no country stands completely alone. Imported inflation is when inflation from one country spills over to another through international trade. This can happen through changes in the currency exchange rate or when an imported good rises in cost. The example above with the price of crude oil and its effect on the cost of eggs is also an example of imported inflation.

The Rare Stagflation

Lastly, there's stagflation – a combination of the words “stagnate” and “inflation.” This is a rare circumstance where inflation remains high, but economic growth stagnates and unemployment rises. Stagflation is usually the result of multiple economic factors and can lead to recession if not addressed. The USA experienced sustained stagflation during the mid 1970s.

The Double-Edged Sword of Inflation

Inflation isn't universally bad. Moderate inflation can actually stimulate economic activity as businesses invest and consumers spend more. It can also benefit property owners who see their investment values rise. However, excessive inflation can be detrimental.

Here's a breakdown of the two sides of the inflation coin:

  • The Good:
    • Increased asset values (property, commodities) can benefit homeowners and investors.
    • Fixed-rate loan payments can feel lighter as payments stay the same amid rising costs.
    • Stimulated economic activity can lead to a thriving economy with increased job opportunities.
  • The Bad:
    • Higher costs for goods and services can strain your budget and purchasing power.
    • Un-invested money loses value over time as inflation increases.
    • Fixed incomes can struggle to keep up with rising costs.
    • Hyperinflation, a situation of extremely high and uncontrolled inflation, can devastate an economy.

The Federal Reserve's Role

The Federal Reserve (often referred to as ‘the Fed’) is tasked with managing inflation, which they accomplish mainly through monetary policy. Their primary tool for this is managing interest rates, or the rate at which banks pay to borrow in the federal funds market. When inflation is low, the Fed may choose to reduce interest rates to encourage borrowing and spending, thus boosting economic activity. However, if inflation starts to climb too high, the Fed can respond by raising interest rates, which cools an overheated economy.

The sweet spot for inflation is somewhere around 2% -- enough to keep the economy healthy and growing, but not so high that it risks spiraling out of control. You can learn more about the Fed and its role in managing inflation by visiting their website: https://www.federalreserve.gov/.