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What Is Inflation? An Overview of Causes & Effects

February 1, 2022
8
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Inflation quantifies the loss of purchasing power as reflected in rising prices for a wide variety of goods and services.

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It only takes a visit to a grocery store to see inflation in action. A pound of bacon costs 29% more at the end of 2021 than a year earlier, according to the U.S. Bureau of Labor Statistics, while beef prices climbed 19% in the same period—that is, if you can find any. Some store shelves were empty as pandemic-related supply chain disruptions and worker shortages—from slaughterhouses to shelf stockers—exacerbated rising prices. 

Consumers felt the pinch elsewhere. It cost 49.6% more to fill a car with gas in 2021 versus the year prior, and prices for autos, trucks, furniture and bedding, hotel stays and plane tickets all climbed by more than 10% during the year amid robust demand and skimpy supply. When consumers complain they can’t afford food, rent, and gas for the car, they’re feeling the bite of inflation.

What is inflation?

In economic terms, inflation is the loss of purchasing power over time that’s reflected in rising prices for a broad range of goods and services. It’s typically expressed as the annual percentage change in the prices of those items. “Inflation captures the price of everything and the rate at which those prices are changing,” says Titan strategist Myles Udland.

In the US, inflation averaged between 1% and 3% in the decade between 2010 and 2020 before surging to 7% in 2021 amid a recovery from pandemic shutdowns, supply-chain bottlenecks, and federal stimulus spending.

This means that a consumer who spent $100 on purchases in December 2021 would have spent about $93.50 a year earlier. If inflation stays at 7% in 2022, they’ll spend $107 at year-end for that same $100 of purchases.

What drives inflation?

Inflation springs from a number of different imbalances in the economy.

  • Demand-Pull inflation. Consumers have money to spend and want more goods and services than producers can deliver. Demand outstrips the limited supply, driving up prices for the items that do exist.
  • Cost-Push inflation. The cost of materials and labor for goods and services increases, often due to scarcity. Producers push their rising costs onto the final product, driving up the price.
  • Built-in inflation. A pattern of persistent demand-pull or cost-push inflation embeds itself in the economy, making inflation a part of life. Workers demand higher wages. Rising wages boost production costs. Prices for finished products edge up. Workers seek even bigger paychecks to afford the pricier items. And the cycle repeats in a wage-price spiral.
  • Budget deficits. A country that spends more than it produces runs a budget deficit. To counter the deficit, the nation’s central bank injects more money into the economy. If the economy isn’t producing the goods and services to support the increased money supply, inflation can result.

In the 2021 bout of inflation, demand-pull and cost-push forces were at play. A revival in consumer demand overwhelmed production and delivery capacity that had been disrupted by the coronavirus pandemic. Meanwhile, shortages pushed prices up even further. For example, shortages of auto parts and a dearth of used cars pushed vehicle prices up almost 40%. At the same time, low interest rates and government stimulus checks put more dollars into consumers’ hands, encouraging them to spend.

Inflation and interest rates

Inflation and interest rates are tightly bound. The higher the inflation rate, the more likely lenders are to raise interest rates to compensate for the decreasing purchasing power of the money they’re lending.

The Federal Reserve plays a central role in price stability and keeping inflation in check. The central bank targets a 2% annual inflation increase, a level that historically has enabled the economy to expand in a predictable way without overheating.

The main tools at the Fed’s disposal are short-term interest rates, which banks then pass on to borrowers. When inflation ticks up, the Fed typically raises rates to discourage borrowing and spending. This slows the economy and works to bring down inflation. When inflation is too low, the central bank reduces rates, making it easier to borrow. This stimulates spending and helps nudge inflation higher, stimulating growth.

Because inflation was much higher in 2021 than the Fed’s 2% target, analysts predicted that the central bank would raise interest rates in the first half of 2022. “Now that it's way above that, they’re likely going to raise interest rates,” says Titan’s Udland.

What is hyperinflation?

Hyperinflation occurs when inflation rises rapidly and uncontrollably—typically more than 50% a month or 1,000% a year. This extreme inflation quickly erodes a currency’s value and consumers’ spending power as prices skyrocket. With a 1,000% inflation rate, a $2 loaf of bread now would cost $22 a year later.

Hyperinflation has two main causes:

  • Government money. A government injects excessive amounts of money into an economy to cover expenses or offset a budget deficit. However, the economy isn’t able to grow fast enough to support the increased money supply, leaving too much money chasing limited goods.
  • Extreme demand-pull. Here, a surge in demand dramatically outstrips supply, sending prices soaring. People begin hoarding, prices rise even faster, and shortages mount, further boosting inflation.

Hyperinflation has historically occurred during war or economic collapse. It’s rare, but once it begins, it can quickly spiral out of control.

What is deflation?

Deflation is the opposite of inflation: Prices of goods and services decline, typically because the money supply decreases, but also because of advances in technology or rising productivity. With deflation, consumers’ purchasing power and the value of their currency increases over time. (Disinflation, in comparison, means the rate of inflation is slowing down, but still remains positive.)

Deflation can be self-perpetuating. Expectations for further deflation can prompt individuals to hold out for even lower prices, reducing demand and slowing growth. In worst-case situations, deflation can signal an impending recession.

The upside of inflation

Consumers forced to deal with rising prices during times of high inflation often bemoan their loss of spending power. But a moderate level of inflation, such as the Fed’s 2% target rate, may offer some advantages.

  1. Economic growth. Moderate inflation can spur economic growth. More money in the economy leads to more demand, which leads to more production and potentially higher salaries.
  2. Increased asset value. People who own property and other tangible assets see the value of their holdings grow.
  3. Higher wages. Wages may increase as workers demand and receive bigger paychecks to keep up with the rising cost of living.
  4. Ability to erase debt. Debtors can pay down their loans with money that’s less valuable than the funds they borrowed.

The downside of inflation

There are many disadvantages to inflation consumers should keep in mind.

  1. Higher prices. The cost of daily life rises across the board as the dollar’s value drops. If prices for goods and services outstrip wage increases, consumers experience a loss of purchasing power.
  2. Depreciating nest eggs. People on fixed incomes, like retirees, see the value of their dollar-denominated nest eggs decline.
  3. Economic uncertainty. Consumers may want to spend and invest less, crimping economic growth.
  4. Diminished standing abroad. Global competitiveness falls as exports become more expensive and trade imbalances expand.

How economists measure inflation

Economists have developed several ways to track and measure inflation.

  • Consumer Price Index (CPI). This index, produced by the Bureau of Labor Statistics, is the most widely reported inflation gauge. It tracks the average change over time of about 80,000 goods and services for all urban consumers. Items are classified into more than 200 categories and eight major groups. Cost of living increases for Social Security recipients and some federal employees are linked to the CPI.
  • Wholesale Price Index (WPI). This index measures the price of goods, generally sold in bulk, before they reach the retail level. The goods are sold to businesses rather than consumers. This index was broadened and rebranded as the Producer Price Index in 1978.
  • Producer Price Index (PPI). The PPI relies on the same formula as the WPI, but includes services in addition to physical goods. The PPI also eliminates the consideration of some taxes in the prices it tracks. Individual indexes are available for nearly all industries in the goods-producing sectors of the US economy.
  • Personal Consumption Expenditures Price Index (PCE). This index, published by the Bureau of Economic Analysis, tracks a broader range of consumer spending. It looks at what people are actually buying each month rather than sticking to a fixed set of goods. The Fed uses the PCE as its preferred inflation measure.
  • Chained CPI. This index considers the purchases consumers make when they substitute one similar item for another. It aims to provide a more accurate picture of what consumers actually buy.
  • Harmonized Index of Consumer Prices (HICP). This index provides a composite inflation gauge for the European Union. It tracks the final costs consumers pay for a basket of common goods. It differs from US consumer prices indexes by including rural consumers and leaving some housing data out of the calculation.

The bottom line

Inflation quantifies the loss of purchasing power as reflected in rising prices for a wide variety of goods and services. It affects consumer spending, employment, wages, investments, interest rates, and government initiatives.

The Fed seeks to maintain a 2% annual inflation rate to keep the economy growing in a predictable way. If inflation rises or falls faster than expected, the Fed can try to restore balance by increasing or reducing short-term interest rates.

While inflation can saddle consumers with higher prices and hurt people on fixed incomes, it can have some positive effects. Inflation can boost the value of assets, spur higher wages, and help the indebted pay loans with money worth less than when they borrowed. A steady, moderate rise in inflation is essential for an economy to expand.

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