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What is inflation and what causes it?

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Inflation is when the dollars in your wallet lose their purchasing power — either because the money supply has dramatically increased or because prices have surged.

It’s an economic phenomenon that has a nasty reputation among policymakers, investors and consumers alike. That’s more so now than ever, with prices surging on almost everything Americans buy — from gasoline and vehicles to furniture and food, according to data from the Department of Labor.

The average U.S. household spent around $3,500 more to buy the same goods and services than it purchased in 2020 and 2019 because of inflation, according to an analysis from the Penn Wharton Budget Model.

Key statistics:

  • Consumer prices rose 7.9 percent from a year ago, the fastest pace since January 1982 as measured by the consumer price index (CPI). 
  • On a monthly basis, prices rose 0.8 percent between January 2022 and February 2022.
  • Energy: Energy prices in February soared 25.6 percent from a year ago, the category with the biggest price gains. Gas prices climbed by 38 percent over the past 12 months, while utility prices soared 23.8 percent and electricity rose by 9 percent.
  • Transportation: Transportation prices soared 23.9 percent between February 2021 and February 2022, with used vehicles skyrocketing 41.2 percent from a year ago and new vehicle prices soaring 12.4 percent.
  • Food: The cost of putting food on the table at home soared in February by 8.6 percent from a year ago, while the price of eating a meal out at a restaurant jumped 7.5 percent, the largest increase on record. Among the groceries that got most expensive were pork (14 percent), poultry (12.5 percent) and eggs (11.4 percent).

Table of contents:

What is inflation?

Inflation occurs when the cost of goods and services in the economy goes up over a sustained period of time. Yet, distinguishing actual inflation from just a price jump can get pretty tricky — because both are different.

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 alone doesn’t count as inflation, as prices in the financial system constantly fluctuate.

From an economics perspective, inflation applies to the broader picture. So while prices on some items can definitely be inflated (think: college costs), it doesn’t equal what economists mean when they say inflation, even though your wallet can surely feel that squeeze.

“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.

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. Policymakers at the Federal Reserve, however, closely follow the Department of Commerce’s personal consumption expenditures index. The indexes are broadly similar and track the same trend, though the consumer price index tends to show higher inflation over time.

Data collectors

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 time 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.

But 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.

Over time, however, both core and headline inflation tend to follow the same path. And regardless of whether it’s volatile, core inflation isn’t an index worth ignoring considering that many Americans spend a majority of their money on buying food, paying for utilities and filling up their gas tank.

Consumers

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 used car last year might’ve endured more inflation than someone who didn’t.

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 impacted by inflation.

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.

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, a high savings rate or strong consumer confidence. 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.

What’s going on with inflation?

The cost of goods and services has steadily increased since World War II, when modern data collection was first made available. That’s partially just because the economy has grown.

But economists like to think about price gains by tracking how much they’ve increased or decreased from the prior-year period. In recessions, the year-over-year inflation rate tends to fall, reflecting disinflationary pressures as millions of consumers remain out of work and demand is subdued. In recovery periods, the inflation rate tends to pick up, reflecting higher demand and wages as individuals find employment again.

High inflation was last a major problem during the 1970s and ‘80s — reaching 12.2 percent in 1974 and 14.6 percent in 1980 — when the central bank moved too slowly to adjust interest rates amid big government spending and two oil-price shocks. The Fed took action by raising interest rates to get inflation back in line — to a target range as high as 19-20 percent. Inflation steadily cooled through the first half of the decade, sinking to 1.9 percent by 1986.

Since then, inflation hasn’t proved much of a threat. Price gains coming out of the Great Recession of 2007-2009 also proved to be tepid at best, mainly due to disinflationary factors from globalization, fewer labor unions, technological innovations and overall stagnant wage growth. Price pressures averaged at 1.7 percent in the years between the end of the Great Recession and the beginning of the coronavirus pandemic.

But in the aftermath of the coronavirus pandemic, inflation came back with a vengeance. Ensnared in labor shortages and supply chain bottlenecks, price surges were at first only impacting goods that needed to be produced at a manufacturing plant, from used and new vehicles to furniture and appliances. Then, demand for the lockdown-deprived activities of attending a sporting event or concert, as well as traveling, flying or staying in a hotel surged after consumers emerged from lockdowns with stimulus checks and ramped-up savings accounts.

Those increases were all assumed to be temporary, clearing as outbreaks lessened worldwide and post-lockdown demand calmed. So far, however, inflation has only gotten worse — and it’s spread to even more categories, impacting services, rents, meals out at restaurants, repair and delivery services, as well as apparel and food. All of that highlights one of the key fears about inflation: Once it’s taken off on the runway, it’s hard to turn around.

The Ukraine-Russia conflict has only managed to make the outlook for inflation worse. Oil prices have soared 82.4 percent from a year ago and nearly 21 percent since Russia invaded Ukraine on Feb. 23, according to the U.S. Energy Information Administration. Other commodity prices, such as wheat and corn, have also surged since the conflict began, considering Russia and Ukraine’s dominance as a global food supplier.

Oil is also an input for thousands of other consumer products, including Aspirin, computers, eyeglasses, tires, toothpaste and shampoo, according to the Department of Energy. All of that means the recent surge could raise prices in more places than just the gas pump.

“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.”

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.

Consequences of inflation

Consumers and policymakers wouldn’t be so fixated on inflation if it didn’t prove to have consequences — for both individual households and the broader economy.

In a high-inflationary environment, there are few places to hide. Think about the money you have sitting in your wallet in your bank account. When prices soar, consumers wouldn’t be able to buy as much with it. Taking into consideration the fact that two-thirds of U.S. economic growth is consumption, that could threaten the vibrancy of growth.

“If prices are rising faster than wages, which tends to occur in cases of high inflation, basically, that means people have less money to spend, less real purchasing power,” the University of Wisconsin’s van Rijn says. “It’s almost like having a pay cut.”

One of the many groups put into a precarious position by inflation are retirees on a fixed income, who may feel the need to cut back on purchases or resort to riskier investments in hopes of generating more income.

Retirees are “at this moment in their lives they really want to reduce their exposure to risky assets and be in a bond portfolio,” says John Cunnison, CFA, chief investment officer at Baker Boyer Bank. “But if inflation begins to run, those bond portfolios, they’re really not going to perform well. They have very limited options in a period of high-sustained inflation.”

Other groups often hit particularly hard by inflation include business owners. They might be forced to pass along higher prices to consumers, but not so much that it dampens demand for their products.

If the cost of borrowing also rises, anyone looking for a loan may also have trouble finding affordable rates, which can further slow down the economy.

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 increase year over year, at least at the U.S. central bank, which is responsible for controlling inflation by adjusting interest rates.

The Federal Reserve 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,” Cunnison says. “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, which may force the Fed to raise interest rates faster to cool down the economy. To cool inflation, Fed Chair Jerome Powell opened the door to one or more half-point rate hikes, which would be the biggest increase since 2000.

“There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability,”

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 prompt companies to increase prices, creating 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.”

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 price gains coming out of the coronavirus pandemic have only lept, repeatedly hitting fresh 40-year highs. Consumer prices climbed 7.9 percent on an annual basis in February 2022. Back in January 2021, however, prices were up just 1.4 percent.

5 ways to protect your money from inflation

Higher inflation should always be something that’s factored into your wallet, experts say. But another way of looking at it means periods of higher inflation shouldn’t change your strategy all that much, particularly if you’re an investor.

1. Equities

Investing in equities may provide a safe haven from inflation, since certain companies still stand to make profits in inflationary times, which in turn may cause their stock prices to rise. In general, avoid parking too much cash on the sidelines in fixed-income investments like government bonds. Experts typically recommend getting income from across your portfolio, including from dividend-paying stocks, preferred stocks and real estate investment trusts.

2. Inflation-indexed bonds

Another beneficial strategy can be incorporating inflation-indexed bonds, the most common being Treasury-Inflation Protected Securities (TIPS), which protect you from inflation by design. They pay a fixed interest rate every six months and an inflation adjustment on a semiannual basis, which applies to the bond’s face value, rather than its yield.

3. Gold

Gold is often viewed by investors as a safe haven during times of inflation or low interest rates, thanks to its proven track record of gains. If you don’t want to actually buy gold and keep it in your home, a convenient alternative is purchasing it through an exchange-traded fund (ETF), which allows you to invest in physical gold or gold mining stocks.

4. A house

Though mortgage rates recently climbed to more than 4 percent after bottoming out at 2.93 percent in January 2021, those who acquired a fixed-rate mortgage at low rates were able to secure cheap funding for up to 30 years. Though property taxes may increase, you can rest assured your fixed-rate mortgage payment will remain the same — unlike the price of rent, which isn’t immune to inflation — even as most of your other expenses continue to increase.

5. An adequate emergency fund

Periods of higher inflation might seem like the wrong time to prioritize saving, but building up an emergency fund of six to nine months’ worth of your expenses is still a wise idea, considering that economic uncertainty rises along with inflation. After that, higher inflationary environments are a particularly important time to make sure that you start searching for a better return — especially for consumers, who risk losing purchasing power.

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Note: Bankrate’s Karen Bennett also contributed to this story.

Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Senior wealth editor