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Copy of Inflation, newsletter icon, 12-18-2021

What Is Inflation?

What Is Inflation?

The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re focusing on a centerpiece of the American economic menu: inflation.

Inflation impacts your life in a variety of ways, from the cost of your favorite workout class and preferred lunch spot to your holiday shopping budget and the prices of your weekly groceries. Inflation recently hit its highest annual rate since 1982, earning itself a rightful seat at the discussion regarding the current and future state of our economy. In addition to being a challenging topic to calculate, its societal effects – from the winners and losers to whether a certain degree of inflation is good or bad for the economy – can be even more complex. Let’s break inflation down a bit more and take a look at what it means for you (note: for the purpose of this article, we will be focusing on inflation in terms of the U.S. economy).

What is inflation?

Inflation represents the decline in purchasing power of a currency, meaning your dollar will not go as far tomorrow as it did today. In other words, inflation represents the rate at which the value of a currency is falling, which results in the rising of the prices for goods and services. Inflation is usually expressed as the annual change in prices for a basket of goods and services, the latter referring to a fixed set of consumer products and services whose price is regularly evaluated, often monthly or annually. The hypothetical basket of goods and services is used to track inflation in a certain market or economy, like the U.S. economy as a whole, and is intended to be representative of the broader economy, adjusted periodically to account for changes in consumer habits. For example, if the price of the basket of goods increases by two percent in a given year, this means that inflation can be stated as two percent. The contrast of inflation is deflation, which occurs when the purchasing power of a currency increases and prices of commodities decrease. 

How is inflation measured?

Inflation is generally expressed as the annual change in prices for a basket of goods and services, which is representative of the broader economy. Depending on the goods and services used, a variety of baskets of goods are calculated and tracked as price indexes. An inflation index is a tool leveraged to gauge broad price changes in a certain economy over a specific period of time. Such an index represents the ratio of the price of an item or a group of items at one time in comparison to the pricing of those same items at another time; however, the index is commonly displayed as a whole number.

In the U.S., three of the most commonly used indexes to gauge inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures (PCE) Price Index.

  1. The Consumer Price Index (CPI) measures the weighted average – meaning the calculation accounts for the varying degrees of importance of the items – of prices of a basket of goods and services that are considered primary consumer needs like food, transportation, and medical costs. The prices used are the retail prices available for purchase by individuals. There are two versions of the CPI that are currently used: the CPI-U and the CPI-W. The CPI-U is a more general index that aims to track retail prices as they affect all urban consumers, while the CPI-W is a more specialized index that seeks to track retail prices as they affect urban hourly wage earners and clerical workers. Overall, changes in the CPI are used to evaluate price changes associated with the cost of living, making it one of the most commonly used statistics for detecting periods of inflation and deflation. The Bureau of Labor Statistics (BLS) reports the CPI on a monthly basis in the U.S.

  2. The Producer Price Index (PPI) comprises a group of indexes that measure the average change over time in the selling prices received by domestic producers for their output. In other words, the PPI measures price changes from the perspective of the seller and differs from the CPI that measures price changes from the perspective of the buyer. The Bureau of Labor Statistics (BLS) parses PPI data into three main areas – industry, commodity, and commodity-based final and intermediate demand – and uses the PPI to measure the domestic output of services and raw goods. The PPI index aims to account for the fact that when producers face input inflation, the increase in these production costs are passed on to retailers and consumers via higher prices. That being said, the PPI is considered an objective number and is often viewed as a more accurate measure of a country’s economic output because it is not impacted by consumer demand.

  3. The Personal Consumption Expenditures (PCE) Price Index is a measure of household expenditures and how such costs change over time. The PCE price index is released monthly by the Bureau of Economic Analysis (BEA) and measures price changes and fluctuations in consumer goods and services exchanged in the U.S. economy. Beginning in 2012, the U.S. Federal Reserve began using the PCE price index as its primary inflation index when making monetary policy decisions like buying or selling government securities and adjusting interest rates. The Fed uses the PCE price index in place of the CPI because the PCE price index includes a broad range of expenditures in comparison to the limited basket of goods used in the CPI. Additionally, the PCE price index uses data through business surveys, which is considered more reliable than the data from consumer surveys used by the CPI, and the PCE price index accounts for short-term changes in consumer behavior, which are not accounted for in the CPI.

Overall, the characteristics behind the PCE price index make it a more comprehensive indicator for monitoring inflation, as it measures things people consume. Our central bank, the Federal Reserve or, more fondly, the Fed, is in charge of keeping inflation in check and keeping prices from increasing too swiftly. The Fed has an inflation target of around two percent and adjusts monetary policy to keep inflation in check.

What causes inflation?

Inflation can occur in almost any product or service, from food, housing, and medical care to cars, jewelry, and clothing. Inflation happens when prices rise as a result of increases in raw materials, wages, and/or production or when demand surges drive prices for goods and services up because consumers are willing to pay more for a product. While there are various factors that can drive inflation in an economy, inflation is typically the product of an increase in demand for products or an increase in production costs. The three main types of inflation are cost-push inflation, demand-pull inflation, and built-in inflation.

  1. Cost-push inflation occurs when increases in the cost of raw materials and wages cause overall prices to increase. Higher production costs tend to decrease supply in the economy, and because the demand for goods is unchanged in this scenario, the consumers are burdened with the production price increases, creating what is known as cost-push inflation.

  2. Demand-pull inflation involves a rising pressure on prices as a result of a supply shortage. Put simply, higher prices result when demand surpasses supply. When consumer demand overtakes the available supply of many consumer goods, demand-pull inflation is triggered, driving an overall increase in the cost of living.

  3. Built-in inflation occurs when workers expect salaries and wages to increase when the prices of goods and services increase to help sustain the cost of living. People’s expectations of future inflation feed built-in inflation; in other words, workers come to expect that their wages will continue to rise in the future as the prices of goods and services naturally tend to rise, causing an increase in the annual cost of living. This can spiral into an unhealthy relationship between prices and wages because the increased wage burden causes businesses to increase the prices of products and services. This cycle tends to repeat until wage increases can no longer be supported. 

Is all inflation bad?

Not all inflation is bad, and a little bit of inflation is generally viewed as desirable, hence the Fed’s two percent target that suggests the government would rather have some inflation as opposed to no inflation at all. Inflation can be viewed positively or negatively depending on the perspective and the rate at which inflation is changing. A few of the advantages of moderate inflation include the enabling of economic growth, positive wage adjustments that benefit employees, and modest price increases that benefit businesses and producers. Inflation is viewed as a positive when it helps boost consumer demand and drive economic growth. For example, individuals with tangible assets – like properties or commodities – mostly favor seeing some annual inflation to raise the value of these assets. Moderate inflation also helps to keep deflation in check, which is good, as the latter can cause a recession.

Of course, there are always cons and disadvantages, and there are some economists that view inflation as a drag on the economy. Inflation can be a concern because it means money saved today will be less valuable tomorrow, diminishing people’s purchasing power. Inflation can also create uncertainty around the economy, which can take a negative toll on investments and the markets and interfere with an individual’s ability to retire due to decreased savings amid an increased cost of living with wages that are unable to keep pace. High inflation and hyper-inflation can derail an economy – there is technically no limit on how high inflation can get – which is why central banks like the Fed exist to monitor these levels and protect the economy from unhealthy inflation paces and levels.

Final Points: What does inflation mean for you?

Inflation affects the U.S. economy in various ways, which is why the Fed closely monitors the indexes and trends linked with such changes in economic behavior. By means of association, inflation also impacts the personal finances of Americans in a number of ways – from weekly grocery bills and education costs to the housing market and the value of retirement savings – and it is important to acknowledge its impact on your financial planning. The greater the rate of inflation, the less your money today will be worth in the future, making it essential for you to adequately save and prudently invest your savings to hedge future inflation and the rising cost of living.