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No one wants to take a pay cut — but with inflation, Americans often have no choice.
Inflation is when the dollars in your wallet lose their purchasing power as prices surge. It’s an economic phenomenon that has a nasty reputation among policymakers, investors and consumers alike. For the first time since the 1980s, price pressures have become a real threat to both household income and the broader economy.
Over the past year, prices have risen on everything Americans want and need, from gasoline and vehicles to furniture, food, rents and services, according to data from the Department of Labor. Inflation in December jumped 6.5 percent from a year ago, still at a 40-year high, but down notably from its 9.1 percent peak in June and reflecting six straight months of improvement. On a monthly basis, prices fell 0.1 percent.
Still, inflation is having a measurable impact on consumers’ wallets. For the past six months, the typical U.S. household has had to spend between $460 and $371 more to buy the same goods and services that it did in 2021, according to an analysis from research firm Moody’s Analytics.
The tide has turned and improvement is now the prevailing trend. Despite the headline and core results meeting expectations, the broad-based improvement that needs to be seen to get inflation truly under control is still lacking.
— Greg McBride, CFABankrate chief financial analyst
- Inflation rose 6.5 percent in December 2022, down from its 9.1 percent peak in June as measured by the CPI. (BLS)
- Grocery prices rose 11.8 percent year-over-year in December 2022. (BLS)
- Energy prices soared 7.3 percent year-over-year in December 2022, led by a 41.5 percent gain in fuel oil. (BLS)
- Gasoline prices are down 1.5 percent from last year, showing further signs of cooling further from its near-60 percent high in June. (BLS)
- Core inflation – that is, inflation without volatile food and energy prices – rose 5.7 percent year-over-year in December 2022. (BLS)
- Rent of primary residence in December 2022 is up 8.3 percent from a year ago. (BLS)
- Average hourly earnings in December jumped a smaller 4.6 percent over the past year, showing Americans’ wages aren’t keeping pace with inflation. (BLS)
- When adjusted for inflation, average hourly earnings fell 1.7 percent between December 2021-2022. (BLS)
- More than 3 in 5 workers (or 61 percent) in August 2022 reported receiving a raise, a higher-paying job or both over the past 12 months. (Bankrate)
- Despite these raises, a majority (55 percent) of Americans say their wages have not kept up with the rise in household expenses. (Bankrate)
- Workers with lower earnings and less education were more likely to find a better-paying position, while pay raises skewed more toward higher earners and the most highly educated. (Bankrate)
What is inflation?
Inflation occurs when the cost of goods and services in the economy goes up over a sustained period of time. Inflation doesn’t happen overnight, and it also doesn’t happen when the cost of one particular good or service goes up.
Say you go to the grocery store and buy a dozen eggs for $2. Then, the next week, that same product is now $4. That price jump alone doesn’t count as inflation, as prices in the financial system constantly fluctuate. Instead, inflation applies to the broader picture.
“We may see prices rise on certain things like gas or milk, but it’s not necessarily inflation unless you see prices rising sort of across the board, across many different products and services,” says Jordan van Rijn, who teaches agricultural and applied economics at the University of Wisconsin’s Center for Financial Security.
Who: Controlling inflation is mainly left up to the Federal Reserve, or the U.S. central bank, which raises or lowers interest rates to influence price pressures.
What: Fed officials mainly use the Department of Commerce’s personal consumption expenditures (PCE) index to gauge what’s happening with price increases. They also, however, look at the Department of Labor’s consumer price index (CPI).
Why: By determining the price of money, the Fed affects every consumer and industry; all rely on credit, either directly or indirectly. Interest rates also affect the price of major consumer products, such as houses and mortgages.
How inflation is measured
The way inflation is measured depends on the gauge. For consumers, the most important price tracker tends to be the Labor Department’s consumer price index, or CPI. Policymakers at the Federal Reserve, however, have closely followed the Department of Commerce’s personal consumption expenditures (PCE) index since 2000. Fed officials also base their inflation goals and projections on the PCE index.
The indexes are broadly similar and track the same trends, though the consumer price index tends to show higher inflation over time. That’s mainly because CPI and PCE use different formulas and weights to calculate inflation. CPI, for example, looks exclusively at how much consumers pay for specific goods in services, while PCE looks at both consumer data and business expenditures. Take health care costs. The PCE price index doesn’t just look at how much households pay out-of-pocket, but also how much employers and the government pay for it.
Both government agencies weigh specific goods and services relative to a consumer’s wallet. PCE, however, is updated more frequently to reflect changes in spending patterns, according to an analysis from the Cleveland Fed.
Generally, both gauges track price changes on a variety of consumer products that reflect the typical basket of goods that a household buys — anything from appliances and furniture, to food, apparel and utilities.
Data collectors create an index tracking how much a typical basket of consumer items changes in price over time. Then, they multiply it to get what’s called a base period. That index then helps economists compare data over different periods to get what’s called the inflation rate. Measuring quarter to quarter provides a quarterly inflation rate, while year to year gives an annual inflation rate.
Put any inflation on a chart, and you’ll notice the cost of goods and services has also steadily increased since World War II, when modern data collection became available. That’s mainly because the economy has grown. Economists like to think about price gains by tracking how much they’ve increased or decreased from the prior-year period.
Some categories tend to be more volatile than others. Food and energy, for example, experience sharp swings month to month. Sometimes, it’s best to strip those categories from the data, in what’s called a core inflation rate, which helps eliminate some of the noise.
Fed Chair Jerome Powell, however, has cautioned against putting too much weight on core inflation. Americans spend the majority of their money on food, utilities and gasoline. Ultimately, it means headline inflation can reflect the broader consumer experience.
“Core inflation is something we think about because it is a better predictor of future inflation, but headline inflation is what people experience,” Powell said at the Fed’s June press conference. “They don’t know what core is. Why would they? They have no reason to.”
Yet, not all households buy the same goods. The inflation rate consumers experience depends on what they buy — meaning someone’s personal inflation rate might end up being lower, or higher, than the overall index.
One person who spends disproportionately more income on gasoline, for example, might feel a tighter inflation pinch right now than someone who currently commutes on public transportation. On the other hand, a consumer who bought a new car last year might’ve felt a greater inflationary pinch.
The Federal Reserve Bank of Atlanta’s “myCPI” calculator gives consumers an idea of what their personal inflation rates are based on how old they are, how many people live in their household, where they live, what they buy and whether they rent or own.
“If 50, 60, 70 percent of your money goes to paying a mortgage or rent and those prices are rising, you’re going to certainly be hit a lot harder,” van Rijn says. “People spending a lot of money on groceries and gasoline, they’re going to still feel the impact of a big increase in headline inflation.”
Research suggests that lower-income households tend to bear the biggest burden from inflation because they rent and spend a greater share of their income on the day-to-day necessities inflation affects.
Penn Wharton’s analysis found that low- and middle-income households’ expenses increased by about 7 percent in 2021, while the country’s top earners saw their expenses rise by 6 percent.
An inflation calculator is a simple way to compare the buying power of money during different periods, by inputting a dollar amount and selecting the months and years for comparison. For instance, $10 in February 2000 had the same buying power as $16.71 in February 2022.
What causes inflation?
Economists like to lump the typical inflation causes into two categories: demand-pull and cost-push inflation. They sound wonky, but they reflect experiences that many Americans are familiar with.
Cost-push occurs when prices increase because production is more expensive; that can include both higher wages or material prices. Companies pass along those higher expenses by raising prices, which then cycles back into the cost of living.
On the flip side, demand-pull inflation generates price increases when consumers have resilient interest for a service or a good. Such demand could result from things like a low jobless rate, strong consumer confidence, low interest rates or robust government spending. A higher demand for products causes companies to produce more to keep up with demand, which, in turn, could lead to product shortages and price surges.
“You could have an economy that revs up very quickly and you end up with demand-pull inflation, where there’s too much money chasing too few goods and services,” says Greg McBride, CFA, Bankrate chief financial analyst.
|Factors that heat up inflation||Factors that cool inflation|
|Increased consumer or government spending, especially spending that takes on debt||Reduced consumer or government spending|
|Increasing money supply||Decreasing or slower-growing money supply|
|Deficit spending, that is, lower taxes without corresponding cuts in government spending||Government surpluses, that is, tax revenues are greater than spending|
|Interest rates that are below the neutral rate of inflation, or increases in the money supply||Interest rates that are above the neutral rate of inflation, or declines in the money supply|
|Highly consolidated industries that push through price increases or pass on their own cost increases||Fragmented industries that have little pricing power|
|A wage-price spiral, in which growing wages push up the price of goods and so workers demand higher wages to compensate||Consumers saving more than they did before, or increases in the net saving rate|
|Expectations of higher inflation in the future||Expectations of lower inflation in the future|
|Supply shocks that sharply reduce output, such as the oil shock of the 1970s||Rapidly increasing supply, perhaps through a technological breakthrough|
|Elevated consumer demand, thanks to an improving job market and widespread employment||Slumping demand, likely caused by a jump in joblessness or a recession|
Even the mere expectation of higher prices can be a bad prophecy. If consumers start expecting prices to pop, they’re more likely to panic buy and demand higher wages. Those two forces combined create the very phenomenon consumers were worried about.
“If people think inflation will be high, prices are going to continue to rise,” says van Rijn, the economics professor. “If you’re an executive setting wages at your company, that depends a little bit on your expectations for how much prices are going to increase next year. As wages go up, then the same thing happens with businesses — they’re going to start raising their prices.”
What happened to inflation in the 1980s?
High inflation was last a major problem during the 1970s and 1980s — reaching 12.2 percent in 1974 and 14.6 percent in 1980 — when the central bank didn’t curb demand enough with higher interest rates during a time of big government spending and two oil-price shocks. Seeing that price pressures were spiraling out of control, the Fed had no choice but to take action. Officials raised interest rates to their highest ever target range of 19-20 percent. Unemployment spiked, and the economy faced its worst recession since the Great Depression at a time, but the strategy worked. Inflation steadily cooled through the first half of the decade, sinking to 1.9 percent by 1986.
Since then, inflation hasn’t proved to be much of a threat. Prices rose an average of 2.5 percent between 1986 and 2020, and inflation coming out of the Great Recession of 2007-2009 proved to be tepid at best, despite government stimulus and ultralow interest rates.
Economists say that’s mainly due to disinflationary factors from globalization, fewer labor unions, technological innovations, overleveraged consumers, income inequality and overall stagnant wage growth. Consumer inflation rose an average of 1.7 percent in the years between the end of the Great Recession and the beginning of the coronavirus pandemic in March 2020.
Why is inflation so high?
In the aftermath of the coronavirus pandemic, inflation came back with a vengeance — thanks to a perfect storm.
Initially, a burst of stimulus checks, government spending and lower interest rates helped prop up demand, while shutdowns drastically slowed the economy. At the same time, many companies cut output in anticipation of slowing demand amid a recession, creating a low supply of goods. Other factories — both within the U.S. and abroad — halted production altogether because infections kept floors closed. However, demand for goods and services sprung back as soon as state governments lifted stay-at-home restrictions. That strong demand and lack of supply helped create inflation.
Those increases were all assumed to be temporary, clearing as outbreaks lessened worldwide and post-lockdown demand calmed. Inflation, however, only got worse. Simultaneously, companies hired millions of workers back as soon as they were allowed to reopen, but they still faced a labor shortage.
Today, an estimated 4 million workers are missing from the job market. That lack of labor supply has added upward pressure to labor costs as businesses compete for workers and lift wages. Facing more expensive inputs and noticing that flush-with-cash consumers were both expecting and stomaching high inflation, businesses turned to lifting prices.
The Ukraine-Russia conflict made the inflation outbreak even worse. Around the outset of the conflict, oil prices soared more than 80 percent from the year prior, according to the U.S. Energy Information Administration. Russia and Ukraine’s dominance as a global food supplier caused other commodity prices to sar, including wheat and corn.
A surge in oil prices ripples across the economy, impacting more places than just the gas pump. Oil is an input for thousands of other consumer products, including aspirin, computers, eyeglasses, tires, toothpaste and shampoo.
“Everything you get off of a store shelf, even the stuff you order online — it’s planes, trains and automobiles to get it there,” McBride says. “There is a filtering-through effect over time, to other goods and probably services, too.”
Today, prices are beginning to cool in goods, but services prices — from dining out at a restaurant to seeking medical care — are where inflation is still most pronounced. Powell has suggested price jumps in those categories are tied to ongoing labor shortages, reflecting increased wage pressures to attract talent.
Inflation called the Fed to action, with officials raising interest rates 4.25 percentage points in 2022 alone, the most in a single year since the 1980s. It’s managed to take some of the edge off, but not all. It highlights one of the key fears about inflation: Once it’s taken off on the runway, it’s hard to turn around.
How much inflation is too much inflation?
A small amount of inflation is actually a good thing. Typically, that’s thought of as a 2 percent annual increase, at least at the U.S. central bank, which is responsible for keeping inflation in check.
The Fed formally set 2 percent as its inflation target in 2012 but has since said it’s willing to let inflation rise above that level for some periods of time, to make up for times when price pressures held below that threshold.
“That basically gives the economy the ability to slowly raise prices,” says John Cunnison, CFA, chief investment officer at Baker Boyer Bank. “For companies, they can slowly increase people’s wages. You’re really looking at the goldilocks inflation — not too little, not too much.”
But increases in inflation that are too drastic could erode consumers’ purchasing power, stifle demand and threaten companies’ profitability.
To be sure, consumer prices have topped 2 percent in the past, but not in a way that compares with the ‘70s-’80s, as well as 2021-2022. That’s because prices in all other periods would oscillate, rising and falling depending on the month. On the contrary, year-over-year prices since the coronavirus pandemic have only leapt, repeatedly hitting fresh 40-year highs in 2022.
When will inflation go down?
Supply-chain issues are improving, and interest rates are now at a level seen as restricting economic growth and curbing demand. Experts in Bankrate’s fourth-quarter Economic Indicator poll project that inflation has likely already peaked from its 9.1 percent annual jump in June.
They’re still, however, a far cry away from the Fed’s 2 percent target — and it might take some time before the Fed’s rapid rate hikes start to have any meaningful effect. Price pressures are projected to hold above the Fed’s target through at least 2024.
Of course, other factors weighing on demand could cause inflation to fall even faster than Fed officials think. The Fed’s inflation battle could send the U.S. economy into recession, which would weigh on demand and, consequently, price increases even more. The U.S. economy has a 64 percent chance of entering a recession this year, according to Bankrate’s Fourth-Quarter Economic Indicator poll.
“At the same time, worker pay is failing to keep up with the rise in prices at the consumer level,” says Mark Hamrick, Bankrate senior economic analyst. “This is a source of stress on household budgets. How that equation unfolds in the months ahead will be key, including whether inflation pressures relent.”