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- Inflation is the increase in the prices of goods and services in an economy over time.
- It could also be thought of as a decrease in the value of your money and purchasing power.
- While a low, steady inflation rate of 2% indicates a healthy economy, high or rapidly changing inflation can become dangerous.
If you notice that it costs more to fill up your car with gas or buy your regular grocery purchases, this is likely due to inflation. Inflation often coincides with a changing economy. But that doesn’t mean it’s always a bad thing — in fact, moderate inflation can actually be a good sign.
But what is inflation really, what causes it, and how does it affect your finances? Here’s everything you need to know about this everyday economic term.
What is inflation?
Inflation is an increase in the prices of goods and services in an economy over a period of time. That means you lose buying power — the same dollar (or whatever currency you use) buys less and is thus worth less. In other words: With inflation, your money doesn’t go as far as it used to.
Remember that modern money really has no intrinsic value — it’s just paper and ink, or, increasingly, digits on a computer screen. Digital currencies (such as cryptocurrencies, stablecoins, and CBDCs) continue to become increasingly popular and accepted as legitimate forms of payment. Still, crypto and stablecoins are decentralized currencies (aka not issued by the government or federal bank) and are limited. The US has yet to issue centralized bank digital currencies (CBDCs) into the market.
Regardless, the value of a currency is measured by two things: What you can buy with it, and how much it can buy.
While it’s easier to understand inflation by calculating goods and services, it’s typically a broad measure that can be applied across sectors or industries, impacting the entire economy. In fact, one of the primary jobs of the Federal Reserve is to control inflation to an optimum level to encourage spending and investing instead of saving, thereby encouraging economic growth.
What causes inflation?
There’s a massive economic literature on the causes of inflation, and it’s fairly complex. But in short, inflation happens because of supply and demand. Keynesian economists emphasize that demand pressures are most responsible for inflation in the short term. Here are the different causes of inflation:
- Demand-pull inflation: When prices rise from an increase in demand throughout an economy, but supply remains the same. A moderate amount of demand-pull inflation can spark market competition, and may actually be an indicator of a healthy economy.
- Cost-push inflation: When supplies are limited (such as from a natural disaster, a struggling economy, or increased production costs), prices rise but supply remains the same.
- Built-in inflation: When the prices of goods and services start rising and businesses prepare for continuous inflation at the same rate by upping prices. Workers demand higher wages, which in turn raises the costs of consumer goods and other services.
Other analysts cite another cause of inflation: an increase in the money supply — how much cash, or readily available money, there is in circulation. Whenever there’s a plentiful amount of something, that thing tends to be less valuable — cheaper. Indeed, many economists of the monetary school believe this is one of the most important factors in long-term inflation: Too much money sloshing around the supply devalues the currency, and it costs more to buy things.
Types of extreme inflation
Hyperinflation
Hyperinflation refers to a period of extremely high, uncontrolled inflation rates, sometimes raising prices over 50% per month for several months. A “normal” or low inflation rate is typically around 2%.
Hyperinflation can be caused by a triggering event, such as war, civil unrest, or natural disasters. Government deficits and the over-printing of money are some of the most common situations that lead to hyperinflation. As folks recognize the possible threat of future inflation, they spend more in fear that their money will soon be worth less. Demand then increases and prices get ramped up.
A recent example of hyperinflation comes from Venezuela, starting in 2016, as a result of deficit spending and excessive money printing. In February 2019, Venezuela’s inflation rate reached an all-time high of over 344,509%. It dropped as low as 114.1% in August 2022 but started rising again in 2023. As of April 2023, it was 436.30%.
Stagflation
Stagflation is a rare event in which rising costs and prices are happening at the same time as a stagnant economy — one suffering from high unemployment and weak production. It can occur when there is a supply shock, or poor fiscal and monetary policies are enacted.
A supply shock is defined as a period of time when the economy’s capacity to produce goods and services is reduced. During the height of the COVID-19 pandemic, there were supply shocks in labor, goods, and services that greatly affected the economy.
An example of fiscal and monetary policies sparking stagflation was in the 1970s “Great Inflation” period, which not only proved that stagnation was possible (as many economists at the time deemed it impossible) but also how devastating it was. In 1973 and 1974, the result of a rapid increase in oil prices in the midst of low GDP caused uncontrollable inflation rates. Fed Chairman Arthur Burns then issued an ineffective monetary policy that let inflation rates continue skyrocketing.
The good and bad of inflation
Inflation is certainly a problem when it comes to ready cash that isn’t invested. Over time, it’ll erode the value of your cash and the funds in your bank account. It’s also the enemy of anything that pays a fixed rate of interest or return.
But individuals invested in stocks or other assets may actually benefit from inflation. Also, a moderate amount of inflation is normal and can be a sign of a healthy economy.
Advantages of inflation
In general, economists like inflation to occur at a low, steady rate. It indicates a healthy economy: that goods and services are being produced at a growing rate, and that consumers are buying them in increasing amounts, too. In the US, the Federal Reserve targets an average 2% inflation rate over time.
If you’ve invested money in the stock market (or other investing markets), you’ll have a better chance of buying low and selling high. On a similar note, businesses may try to “outrun” inflation costs by investing more in research, development, and new technologies.
Low inflation rates can encourage increased consumer spending, which in turn boosts the economy. Instead of putting away money for a rainy day, people are more motivated to spend and put the money back into the economy. When consumer spending increases, businesses gain more profit and are more likely to invest in development, production, and new technologies. Businesses are also more likely to invest more in their own workers and increase wages to balance out the effects of inflation.
However, it’s important to recognize that the economy only benefits from moderate inflation rates. High inflation rates often have extremely negative effects on consumers, businesses, and the economy as a whole.
Disadvantages of inflation
When inflation starts mounting higher and higher, it can become a real problem. It’s a problem because it interferes with how the economy works as currency loses its value quickly and the cost of goods skyrockets. Uninvested money loses a lot of its value, especially cash or bonds. Wages can’t keep up, so people stop buying. Production then stops or slows, and an economy can tumble into recession.
The problem of where, how, and when new money enters the economy can also significantly hurt the economy. Usually, new money is distributed to certain individuals and businesses in the hope that the money eventually circulates back through the economy and is fairly distributed. But this can take time.
How to measure inflation
Inflation is measured by the inflation rate, which is the percent change in prices from one year to another. The inflation rate can be measured in a few different ways:
Consumer Price Index (CPI)
The US Bureau of Labor Statistics measures the inflation rate using the Consumer Price Index (CPI). The CPI measures the total cost of goods and services consumers have purchased over a certain period using a representative basket of goods, based on household surveys. Increases in the cost of that basket indicate inflation, and using a basket accounts for how prices for different goods change at different rates by illustrating more general price changes.
Producer Price Index (PPI)
In contrast with the CPI, the Producer Price Index (PPI) measures inflation from the producer’s perspective. The PPI is a measure of the average prices producers receive for goods and services produced domestically. It’s calculated by dividing the current prices sellers receive for a representative basket of goods by their prices in a specific base year, then multiplying the result by 100.
The PPI is useful in its ability to forecast consumer spending and demand, but the CPI is the most common measure and tends to have a significant influence on inflation-sensitive price forecasts.
Personal Consumption Expenditures Price Index (PCE)
The Bureau of Economic Analysis measures the inflation rate using a third common index, the Personal Consumption Expenditures (PCE). The PCE measures price changes for household goods and services based on GDP data from producers. It’s less specific than the CPI because it bases price estimates on those used in the CPI, but includes estimates from other sources, too. As with both other indices, an increase in the index from one year to another indicates inflation.
The PCE is less well-known than the CPI, using different calculations to measure consumer spending. It’s based on data from the GDP report and businesses and is generally less volatile than the CPI because its formula accounts for potential price swings in less stable industries.
Controlling inflation
Inflation can be controlled by governments through their monetary policy with three primary levers: interest rates, bank reserve requirements, and money supply.
- Interest rates: Increasing interest rates makes it more expensive to borrow money. So people spend less, reducing demand. As demand drops, so do prices.
- Bank reserve requirements: Increasing reserve requirements mean banks must hold more money in reserve. That gives them less to lend, reducing spending and leading (hopefully) to deflation, a drop in prices.
- Supply of money: Reducing the money supply reduces inflation. There are several ways governments do this; one example is increasing interest paid on bonds, so more people buy them, giving more money to the government and taking it out of circulation.
Investments that beat inflation
Investing for inflation means ensuring that your rate of return outpaces the inflation rate. Certain types of assets may beat inflation better than others.
- Stocks: There are no guarantees with the stock market, but overall and over time, share prices appreciate at a rate that typically exceeds the inflation rate. Most index funds also post returns better than inflation.
- Inflation-indexed bonds: Most US Treasuries pay the same fixed amount of interest — whose value erodes if inflation is rampant. However, with one type of bond, called Treasury Inflation-Protected Security (TIPS), interest payments rise with inflation (and fall with deflation).
- Physical assets and commodities: Alternative investments — often, tangible assets like gold, commodities, fine art, or collectibles — do well in inflationary environments. So does real property. “Returns on investments in real estate have kept up with, or surpassed, rates of inflation for many periods in the past,” says Zach Ashburn, president of Reach Strategic Wealth. That’s because these physical assets, unlike paper ones, have intrinsic value and are sold and priced in markets outside the conventional financial ones.
More generally, Asher Rogovy, chief investment officer at Magnifina, suggests that it’s best to avoid nominal assets in favor of real assets when inflation’s on the upswing. Real assets, like stocks and real estate, have prices that fluctuate or vary freely. Nominal assets, like CDs and traditional bonds, are priced based on the fixed interest they pay and will lose value in inflationary times.
Protecting yourself against inflation
Inflation means costs and prices are rising. When they do, paper money buys less. Low, steady inflation is good for the economy but bad for your savings. Ashburn says, “While having cash available is important for financial security, cash will see its value slowly eaten away by inflation over time.”
To beat inflation, don’t leave your cash under your mattress — or in any place where it’s stagnant. It has to keep earning.
Instead, aim to structure your portfolio so that it provides a rate of return — one that’s hopefully better than, or at least keeps pace with, that of inflation, which is almost always happening. If you do, it means that your investment gains really are making you richer — in real terms.
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