What Is Inflation? 

If you’ve turned on the news at any point since 2021, you’ve probably seen a headline referring to inflation.

In March 2021, the U.S. saw the inflation rate surpass a ‘healthy' 2%, impacting businesses and end consumers alike. Rising prices have broad effects, influencing significant life decisions such as home purchases or pursuing grad school

What is inflation, its origins, measurement methods, government control, and its impact—are modest inflation levels beneficial or always undesirable?

Finally and most importantly, what can you do to protect yourself and your finances from inflation?

What is inflation? 

Inflation is the rate of increase in the price of goods and services over time. We typically measure it year-by-year, so 10% means that something that cost $100 last year costs $110 this year. 

Some economists have a slightly different definition for inflation, calling it the gradual loss in a currency’s purchasing power over time. But both definitions are essentially saying the same thing: as prices rise, the value of a dollar (or dinar, or peso) lowers. 

How do we measure inflation? 

The most common measuring stick for inflation is the Consumer Price Index (CPI). The U.S. Bureau of Labor and Statistics (BLS) calculates the Consumer Price Index by collecting the prices of goods and services from 23,000 retail establishments across 75 urban centers representing 93% of the U.S. population. And since the cost of housing is a major factor in the overall calculation of inflation, the BLS also collects rent data from about 50,000 landlords or tenants. 

Once they’ve got all this data, the BLS then calculates the average overall price of different goods and services (e.g. eggs, furniture, women’s dresses, used cars and airline fares). That way, they can measure the inflation of that specific product or service over time as well. 

Then, to calculate the overall Consumer Price Index, the BLS gives weight to the categories of goods and services based on their importance to the average consumer. For example, “Cakes, cupcakes, and cookies” accounts for just 0.207% while “Shelter” accounts for a suitably heftier 34.413%. 

Then, the BLS puts all of that data into a complex, proprietary algorithm, cranks the handle, and out comes the CPI. 

At the time of this writing, the current CPI for “All Items” is 3.7%, meaning on average, consumer goods and services are roughly 3.7% more expensive than they were this time last year. 

In addition to Consumer Price Index, you might also hear the term Producer Price Index (PPI) to describe inflation. PPI is a measure of inflation from the seller’s point of view instead of the consumer’s,  taking into account production costs — that is, the cost of goods and raw materials to make the stuff we buy. 

What causes inflation? 

You’ve probably heard that inflation is caused by the government printing too much money. That’s certainly one of the causes (and we’ll look at some historical examples of “hyperinflation” below), but in most cases, governments don’t cause inflation — we do!

Here are the four main causes of inflation and how they work: 

Demand-pull inflation

Demand-pull inflation occurs when there’s an increase of cash (or the ability to borrow cash) in the economy, and as a result, consumers start spending more than they usually would. They buy the new iPhone, the nicer car they’ve always wanted or simply go out to eat more often. 

As a result of this surge in spending, the companies selling all this stuff more or less realize that they can raise the price of their existing supply without suffering a loss in demand.

For example, during the pandemic, used car dealers realized that there were probably 10, sometimes 100 interested buyers for every one car on the lot. So if they raised the price from $40,000 to $45,000 knowing that someone would probably still buy it (and more often than not, they did). 

So demand-pull inflation occurs when there’s “too much cash chasing too few goods,” as many economists say. All four macroeconomic buyers—households, businesses, governments, and foreign entities—can drive demand-pull inflation, not solely attributable to us.

Cost-push inflation

Cost-push inflation, by contrast, is when demand stays the same but the supply becomes more expensive to produce. The seller, therefore, passes the added production costs down to the consumer in the form of a raised price tag. 

To illustrate cost-push inflation, let’s look at how the war in Ukraine affected European gas prices. In 2019, the European Union purchased more than half its oil from Russia alone. And when the EU imposed sanctions, it meant the non–Russian oil suppliers had to work double-time (quite literally) to meet the same demand. They had to buy more ships, hire more workers and build more refineries, and eventually, those added costs got passed down to the average European commuter who paid 90% more at the pump. 

Demand-pull indicates increased demand for the same supply, while cost-push reflects the same demand for a smaller or pricier supply.

Increased money supply

The third source of inflation occurs when there’s a large influx of money into the economy. The government printing money or a foreign entity buying real estate with a foreign currency converted to USD may occur.

Either way, when too much new cash arrives but the supply doesn’t change, the demand-pull effect occurs. This is pretty much what happened when the U.S. sent $1 trillion in cash to Americans during the pandemic — it obviously helped a lot of people, but it also caused supply shortages which led to a spike in demand-pull.

But things could definitely be worse than a peak of 9.1%. Throughout the 1990s and 2000s, the government of Zimbabwe printed untold sums of cash to fund the military and buy food from other countries. As a result, the rate of inflation went from 6% in 1996 to 89.7 sextillion percent in 2009, stopped only by the adoption of the U.S. dollar. 

Inflation expectations

Finally, inflation expectations arise when there's a widespread anticipation of high future prices. This leads to preemptive demands for higher wages, increased pricing, and advanced purchases of expensive items.

A self-fulfilling prophecy ensues: demand-pull from increased demand, cost-push from higher wage demands, leading to a surge.

This is exactly what happened during the “Great Inflation” lasting from 1965 to 1982. Factors like the Vietnam War, the sudden death of the Gold Standard and existing, creeping inflation caused the average American to lose faith that the government could control inflation. So they demanded higher wages, which made prices rise, which led to higher wage demands and so forth until inflation peaked at nearly 15% in 1980. 

It wasn’t until the Federal Reserve Bank under Jimmy Carter rose interest rates to a staggering 19% that the U.S. economy froze and inflation tumbled to a palatable 5%. 

How does the government “control” inflation? 

This oversimplifies a complex system but provides a gist of how the financial system's essential pillar operates.

The Federal Reserve System of the United States, or the Fed for short, is what’s known as a central bank. A central bank is a government-run bank that essentially governs all the other banks. Every country has one, since it’s critical to controlling the economy.  

The Fed permits banks, such as Chase and Wells Fargo, to keep a set amount in interest-bearing reserves. Think of them like savings accounts for banks. 

Now, the Fed controls the interest rates of those reserves. So when the Fed raises interest rates, it’s encouraging banks to leave more money in reserves. When it lowers interest rates, it’s encouraging banks to take their cash out and lend it around. 

Here’s how that affects inflation: 

Let’s say it’s 2021 and the Fed has the interest rate at 0.15%. NBE aims to lend reserves to generate interest, acknowledging the lack of profit on its current reserves.

The next day, you come knocking and ask for a mortgage. The NBE goes “Heck yes! Perfect timing — we’ll give you one for 3.15%.” You’re happy, the bank is happy and people come flooding in for cheap mortgages. 

Now let’s say it’s 2023. The interest rate on reserves is now 5%, so the NBE is happy to keep its money where it is.

But you come knocking for a mortgage nonetheless. 

“So… Here's the thing,” NBE says. “We can definitely write you a mortgage. But since we’re making 5% on our reserves… we’re going to have to charge you 8% to make it worth our while.” 

Banks' reduced lending prompts consumer thriftiness, delaying expenses like vacations, prolonging possessions' lifespan, and cutting back on outings.

This slows down demand-pull inflation. 

Faced with reduced demand, businesses hesitate to raise prices, irrespective of production costs, affecting the overall pricing dynamics. They may even lower prices before their existing supply spoils. 

This slows down cost-push inflation. 

To recap: 

1. The Fed raises interest rates
2. Banks are encouraged to save more and lend less
3. Banks charge higher interest rates to make lending worth their while
4. Higher interest rates encourages everyone to spend less and save more
5. Slower demand leads to price stability and lower prices

This is a simplified overview; numerous factors, explored in extensive Econ textbooks, contribute to understanding inflation and the Fed's role.

Is inflation good or bad? 

Inflation is like saturated fat. 

Even though it’s widely considered “bad,” you actually do need a small amount of it to survive. The key is to keep it low and controlled, because bad things happen when it’s too high or too low. 

High inflation sparks panic spending, supply shortages, and ‘wage spirals'—escalating wages drive prices, creating a self-perpetuating cycle.

Low inflation signals insufficient spending, impacting business profits and potentially leading to worker layoffs. A lack of foreign investments raises concerns about external financial inflow.

That’s why the Fed actually targets a 2% inflation rate each year. This is considered a healthy number where spending, lending and wages are all working together in relative harmony. 

How can you personally deal with inflation? 

The harsh reality of rising prices is that the purchasing power of your hard-earned cash continuously diminishes. However, strategic financial management allows you to counteract this decline and even thrive.

• Open a high-yield savings account: It’s best not to keep too much cash in your checking account because it’s just going to lose purchasing power there due to inflation. Instead, toss as much as you can in a high-yield savings account (HYSA) where it’s still accessible, but it’s generating ~4% APY to combat inflation.
• Consider buying some I bonds:  In addition to your regular investments, you can also protect your capital from inflation by buying Series I Savings Bonds from the Treasury. I bonds are risk-free investments with an interest rate that resets every six months to match the current rate of inflation.
• Get the right rewards credit card: Sure, inflation may be 2% each year — but you can earn 3% or even 5% back on most purchases if you use the right rewards credit card.
• Follow the avalanche method to pay off debt faster: The “avalanche method” involves paying off your debts in order of highest-to-lowest interest rate. This may not directly combat inflation, but it can help you get out of debt much faster.
• Connect with a financial advisor: With the Consumer Price Index constantly fluctuating, you might be wondering: when is the right time to buy a house/car/refinance my student loans? This is a great question for a financial advisor who understands both the market and your current financial situation. A great way to connect with one is to ask for a referral from friends, family or social media. 

Inflation is an inevitable by product of a functioning economy. Plan and mitigate inflation's impact by strategic spending and saving, even if the Cinnamon Toast Crunch prices rise.

FAQs

Why is inflation so high right now? 

Various factors drive high inflation in late 2023, including demand for affordable housing, rising wages, and Russian sanctions.

When will inflation go down? 

Thankfully, it already has. It’s gone from 9.1% to 3.7% in November 2023, and the Fed conservatively estimates it should hit 2% by 2026.

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