Key takeout
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Inflation is a sustained rise in prices of goods and services, which can negatively affect purchasing power and stretch your budget.
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The Federal Reserve targets an annual inflation rate of 2% as a sign of a healthy economy.
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Inflation can be caused by factors such as increased production costs, high demand for goods and services, and expectations for higher inflation.
No one wants to cut their pay — but inflation, Americans often have no choice.
Inflation poses a real threat to both household incomes and the broader economy for the first time since the 1980s when Americans were trapped with willingness to burn from the coronavirus pandemic lockdown. It is an economic phenomenon that has a troubling reputation among policymakers, investors and consumers.
According to the National Economic Research Bureau, prices have risen 23.7% since February 2020 and February 2020. This means that Americans would need around $1,237 to purchase the same item or service as originally priced at $1,000. These small changes can add up over time, with additional costs totaling nearly $2,844 over 12 months.
High inflation not only makes it affordable, but also makes it more complicated to save emergencies and invest in retirement. Needless to say, Federal Reserve officials have rapidly raised interest rates to put a burst of US living under control, even though it meant risking a recession and slowdown in the job market. Fed officials cut key benchmark interest rates at their September meeting and followed up two more interest rate cuts, but borrowing costs are still higher for more than a decade.
Not all inflation is bad inflation, and prices always rise across the economy due to supply and demand-related factors. This is what inflation is, what it isn’t, and what it isn’t, and why it’s so important to your wallet.
Latest insights on inflation
What is inflation?
Inflation occurs when items that consumers regularly purchase (such as haircuts and medical services to products such as home appliances and furniture) increase over a sustained period. Inflation does not occur overnight. Also, it does not incur even if the costs of a particular product increase.
Let’s say you go to the grocery store and buy dozens of eggs for $2. Then the following week, that same product costs $4. The prices in the financial system fluctuate constantly, so that price jumps alone do not count as inflation. Especially food and energy costs. Instead, inflation applies to wider images.
“Prices can rise with certain things like gas or milk, but not necessarily inflation unless prices are rising across many different products and services,” says Jordan Vanline, who teaches agriculture and applied economics at the University of Wisconsin’s Financial Security Center.
How much inflation is there too much?
Prices should rise every year across the US economy. A bit of inflation is seen as a sign of a healthy economy, allowing businesses to maintain employment and consumer salaries to continue to grow. Fed officials target an inflation rate of 2% per year. It is a common goal post of inflation that is currently considered appropriate.
“It basically gives the economy the ability to slowly raise prices,” says John Cunnison, CFA, vice president and chief investment officer at Baker Boyer Bank. “For businesses, they can slowly raise wages for people. You’re really looking at Goldilock’s inflation.
However, inflation of the wallet-harming type occurs when prices burst at rates much faster than 2%, and American salaries can’t keep up. Consumers will have to make tough decisions about what to buy and what to refrain from. Sometimes, if inflation affects important essentials and you turn to your credit card debt, there may be no way to avoid those price pressures. Unpredictable price increases can also be a problem for the economy, making it difficult for businesses to set pricing and prepare for the future.
How to measure inflation
There are two main ways to measure inflation.
- Bureau of Labor Statistics Consumer Price Index (CPI); and
- The Ministry of Commerce’s Personal Consumption Expense (PCE) Index.
CPI is primarily important for consumers. BLS regularly provides information on how prices change with almost 400 individual items, just as specific as peanut butter and stationery. The Social Security Administration (SSA) uses a subset of CPIs to determine annual cost-of-living adjustments (COLA), while the Internal Revenue Service (IRS) uses the CPI to inform adjustments to federal tax brackets, affecting the index to hundreds of millions of Americans.
On the other hand, PCE is extremely important to the Fed, but its consumer impact, although indirect, is still huge. The gauge can help policy makers decide what to do next with the key benchmark interest rates that affect how much consumers pay to borrow money. Officially, it targets PCE instead of CPI.
The two indexes show different photos of inflation, so their preference is important. Both measurements capture the same trend, but CPI has historically tended to rise faster than PCE. This is mainly because we calculate inflation using equations and weights with different indexes. For example, shelters are considered one of the most important items in the index of the entire CPI. This coincidence is one of the hottest corners of current inflation. According to BLS calculations, prices in April may be the reason for the 2.3% increase from a year ago. This is two-tenth points, 2.1% above the overall inflation rate of 2.1% for the PCE index for the same month.
Meanwhile, CPI considers both consumer data and business spending, while only considering how much consumers pay for a particular product or service. PCE also takes into account consumer alternatives. For example, people who replace meat with seafood for a month because it is cheap may think they have a higher food cost.
How economists track inflation
To gain a broader sense of inflation, economists usually track changes in price index levels over the past year. We also analyze three- and six-month moving averages that will help shed light on recent trends. On the other hand, stripping away from the volatile food and energy categories will look at the underlying inflation that is often referred to as “core” prices.
How consumers track inflation
However, households have a completely different perception of the US economy.
First of all, many people tend to pay attention to price levels rather than rates of change. For example, slowing inflation does not mean prices are falling. Consumers who remember how much it costs to buy a grocery cart or fill a gas tank may still feel in a pinch of inflation.
On the other hand, not all households buy the same item. The consumer experience of inflation depends on what they buy. This means someone’s personal inflation rate can be lower or higher than the overall index. For example, drivers may be in a larger inflationary crisis than public transport users as insurance and repair costs continue to rise sharply. Families may find inflation worse if they send their children to college or pay for medical care.
What causes inflation?
Economists summarise the causes of inflation primarily into two categories: demand pull and cost push inflation. These terms sound unstable, but reflect the experiences that many Americans know well, especially after the coronavirus pandemic.
However, there may be other forces at work that do not clearly fit into any category. And, as in the case of post-occurrence, all of these inflationary forces can intersect, creating even more difficult price problems to resolve.
1. Cost Push Inflation
Cost push inflation occurs when prices rise as they rise, as production increases. This is because wages and material prices are high. Companies pass these higher costs by increasing prices, which will return to the cost of living.
2. Inflation of demand pull
Conversely, when consumers have a resilient interest in a service or good, demand pull inflation occurs. This kind of demand can arise from things like low unemployment, strong consumer trust, or low interest rates. However, companies cannot keep up with their robust demand all the time, and do not lead to product shortages or as a result of a surge in prices.
You can have a very quick turn economy and ultimately will be inflation of demand pull.
– Greg McBride, Bankrate Chief Financial Analyst
3. Expectations for higher inflation
Even mere expectations of a higher price could be a bad prophecy. If consumers start to expect prices to pop, they are more likely to buy or demand higher wages. These two forces combined created a very phenomena that consumers were concerned about.
“If people think that inflation is high, prices will continue to rise,” says Van Lizin. “If you’re the executive setting for your company, it depends a bit on your expectations about how much prices will rise next year. The same thing happens in the business as wages rise – they start to raise prices.”
| Factors that heat up inflation | Factors that cool inflation |
|---|---|
| Increased consumer or government spending, particularly expenditures that underwrite debts; | Reducing consumer or government spending |
| Increased money supply | Decreased supply or slow growth money supply |
| Reducing taxes without deficit spending, i.e. corresponding government spending reductions | Government surplus, that is, tax revenue is greater than expenditure |
| Interest rates below the neutral rate of inflation, or increased money supply | Interest rates above the neutral rate of inflation, or a decrease in money supply |
| A highly integrated industry driving price rises will take over its own rising costs | Fragmented industries with little pricing power |
| Wages rise spiral. Increased wages push the price of goods and demand higher wages to compensate workers | Consumers are saving more than before, or increasing net saving rates |
| Expectations for higher inflation in the future | Expectations for a decline in future inflation |
| Supply shocks that significantly reduce production, such as the oil shock of the 1970s. | Supply will increase rapidly, perhaps through technical breakthroughs |
| Increased consumer demand thanks to improved job markets and widespread employment | Slow demand that can be caused by unemployment or a recession jump |
A brief history of US inflation
High inflation was the last major issue in the 1970s and 1980s. It reached 12.2% in 1974 and 14.6% in 1980. The central bank did not curb sufficient interest rates with large government spending and high interest rates during two oil price shocks.
Then-chairman Paul Bollucer decided to significantly change the way Fed officials set interest rates and drive those borrowing costs to the 19-20% range. Unemployment rates skyrocketed, and the economy faced the worst recession since Great Repression. No matter how painful it was, the strategy worked. Inflation steadily cooled down until the first half of the decade, sinking to 1.2% by December 1986.
Since then, inflation has not proven to be a threat to date. Prices rose by 2.4% per year between 1990 and the end of 2019, and inflation, born from the Great Recession of 2007-2009, proved to be slippery at best despite the ultra-low interest rates. Economists slowly condemned the recovery of the crisis after financial year, mainly along with other layoff factors such as globalization, technological innovation and aging. However, consumers may be surprised to remember that they actually spent their ERA, thinking that the Fed could be harder to stimulate the economy in the event of a recession.
What’s the latest inflation?
Check out our analysis of where prices are currently rising the most and the most expensive bank rates since the pandemic.
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Extreme inflation types
Rapid inflation can always be painful, but there are other flavors of price pressure that are even more dangerous for the economy and American purchasing power.
1. Stagflation
Stagnation occurs when unemployment rates rise, demand falls and economic growth slips, but on the contrary, inflation is not disrupted. Typically slowing growth and increasing unemployment have an opposite relationship with inflation. The weight of spending will be reduced. There are low expenses for businesses that can expand or invest in.
Only a specific set of conditions leads to this type of inflation. The main factor is usually a supply shortage, which continues to compare and examine the production capacity of the US economy. There are also varying degrees of stagflation. In the worst-case scenario, the financial system could fall into a recession as inflation surges. If it’s mild and still painful, the growth may be lukewarm.
Anyway, the environment proves particularly challenging, as traditional ways to control inflation – raising interest rates – is not immediately effective.
2. Hyperinflation
Hyperinflation occurs when prices rise significantly, and can sometimes be considered to be around 50% per month. Think about it: the current economy of Germany or Venezuela or Zimbabwe in the 1920s. However, only a rare combination of policy-making failures leads to this environment, from explosive spending in government and debt to rapid growth in the country’s money supply.
How can consumers protect against inflation?
- Find the best place to park your cash: Not all inflation is bad inflation, but consumers who maintain their money under mattresses and brick-and-mortar stores will lose the ground based on inflation. Historically speaking, investing in financial markets is the best way to increase purchasing power over time, whether it’s 50 years or 50 days after retirement. However, bank rate picks for the best high-yield savings accounts will help Americans stick to their buying power by making more profit than overall inflation.
- Keep your budget: A period of high inflation underscores the importance of closely monitoring your budget. Make sure you know how much you are spending and how much you can spend.
- Shop at the most affordable prices: It’s hard to escape inflation when prices are rising all around, but using technology to find the cheapest products on the market and comparing options can lead to significant savings in the long run. Better yet, find coupons and see if there is a retailer price check.
- Maintain emergency funds: When consumers are afraid of losing their purchasing power, they may think it’s not wise to keep cash on the bystanders, but that’s when they focus most on building cash cushions. The risk of a recession is by no means zero, especially if interest rates continue to rise and tariffs threaten to slow economic growth.