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.

Inflation is 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.

In 2021, the average U.S. household spent around $3,500 more to buy the same goods and services that it purchased in 2020 and 2019 because of inflation, according to an analysis from the Penn Wharton Budget Model.

Key statistics:

  • Inflation peaked at 9.1 percent in June 2022, as measured by the CPI, but fell in subsequent months, hitting 8.2 percent in September 2022. (BLS)
  • Food prices rose 11.2 percent year-over-year in September 2022. (BLS)
  • Energy prices soared 19.8 percent year-over-year in September 2022, with piped natural gas running 33.1 percent higher. (BLS)
  • Core inflation – that is, inflation without volatile food and energy prices – rose 6.6 percent year-over-year in September 2022. (BLS)
  • Cost for cars kept rising, with new vehicle costs up 9.4 percent and used vehicles climbing 7.2 percent in September 2022. (BLS)
  • Shelter costs were also notably higher year-over-year in September, up 6.6 percent. (BLS)
  • Wages have been rising for many (but not most) Americans, with 48 percent reporting a raise in the 12 months to August 2022. (Bankrate)
  • Despite these raises, a majority (55 percent) of Americans say their wages have not kept up with the rise in household expenses. (Bankrate)
  • Pay raises in the year to August 2022 tended to skew to those earning more money 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. 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.

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Bankrate insights

Who: The Federal Reserve, the U.S. central bank, has a dual mandate: to control inflation and maintain employment to keep the economy functioning.

What: Inflation is often defined by looking at changes in the consumer price index, though it has multiple variants and other indexes may be used, too.

Why: By raising or lowering interest rates, the Fed can have a big impact on consumers. In particular, interest rates affect the price of major consumer products such as houses and mortgages. But by pricing money, the Fed also affects every consumer and industry because they all rely on credit, either directly or indirectly.

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

The CPI and PCE differ in many ways, including the formulas used to calculate them and how the basket of goods and services is weighted in the calculation. Another difference is how the indexes measure inflation, with the CPI looking at the change in expenses for just households themselves and the PCE looking at households as well as expenses paid for them by other organizations (such as health insurance).

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 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.

During the coronavirus pandemic and after, surging inflation was created from multiple sources. 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. However, employment sprung back and with it demand for goods and services.

That strong demand and lack of supply helped create inflation, as highly consolidated American industries were able to pass along price increases to everyday consumers. Simultaneously, many companies have been unable to find adequate staffing, at least at prices they’re willing to pay. That lack of labor supply has also added some upward pressure to labor costs.

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

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.”

Why is inflation so high?

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 1980s — 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 to be 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, overleveraged consumers, income inequality 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 in March 2020.

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 amped-up savings accounts.

After hitting a plateau of 5.4 percent in the middle of 2021, inflation picked up through the end of 2021. 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 managed to make the outlook for inflation 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. Other commodity prices, such as wheat and corn, also surged since the conflict began, considering Russia and Ukraine’s dominance as a global food supplier, though prices have come well off their highs.

Oil is also an input for thousands of other consumer products, including aspirin, computers, eyeglasses, tires, toothpaste and shampoo. So a  surge in oil prices ripples across the economy, more so 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.”

Inflation seems to have hit a peak of 9.1 percent in June 2022, even as the Fed rapidly hiked interest rates to fight it. In the months following, inflation has trended a bit down, as those rate hikes began to filter their way into the economy and the central bank raised rates still further.

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.

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,” 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, which has forced the Fed to raise interest rates faster to cool the economy. As of November 2022, the Fed has made four straight massive increases of 75 basis points to the fed funds rate.

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 leapt, repeatedly hitting fresh 40-year highs in 2022. Inflation seemed to peak in June 2022, however, at 9.1 percent. Back in January 2021, however, prices were up just 1.4 percent.

When will inflation go down?

As of November 2022, inflation may have already peaked, reaching 9.1 percent in June 2022. Subsequent months saw inflation falling slowly but steadily, as the effects of higher interest rates, lower liquidity and expectations of more of each worked their way through the economy.

With short-term interest rates rapidly rising and the liquidity of money markets rapidly declining, many experts see the spike in inflation being fully squashed in 2023. The Fed’s own projections suggest that policymakers expect interest rates to peak above the 4.50 – 4.75 percent APY level. And the Fed has promised repeatedly that it will not back down on crushing too-high inflation.

Many market watchers expect the economy to dip into a recession by the first quarter of 2024, if not in 2023. An October Bankrate survey shows that experts give a 65 percent chance of a recession by the first quarter of 2024. If that occurs, rates could move sharply lower.

The net result of the Federal Reserve trying to quell inflation so rapidly is that it may well send the U.S. economy into recession. In fact, a broad expectation of a recession due to the Fed’s actions will help steer the economy in that direction anyway. As the situation unfolds, consumers and investors can turn to Bankrate’s recession watch coverage for current trends, what to expect from the stock market and how consumers can prepare and weather the downturn.

Note: Bankrate’s Karen Bennett contributed to a previous version of this story.