What Is Inflation? How It Works and Why It Matters

Inflation is a broad increase in the prices of goods and services in an economy over a period of time. When prices rise, consumers' purchasing power declines, meaning they can buy less with the same amount of money. The wide-ranging impacts of inflation make it one of the most closely watched economic indicators.

Imagine a family that spends $5,000 each month on housing, food, healthcare, transportation, and other expenses. If inflation averages 5% over the next year and their spending patterns don't change, buying the same goods and services would cost $5,250 a year later. In other words, inflation can reduce purchasing power by increasing the amount consumers must spend to maintain the same standard of living.

Inflation can occur for a variety of reasons, but economists generally divide inflation into two broad categories: demand-pull inflation and cost-push inflation.

Demand-pull inflation occurs when the demand for goods and services grows faster than the economy's ability to produce them. When this happens, price levels tend to rise as consumers compete for the limited available supply. Common causes of demand-pull inflation include:

• Strong economic growth: Periods of strong gross domestic product (GDP) growth can lead to competition for labor, materials, and other resources, resulting in upward pressure on consumer prices.
• Fiscal policy: Government spending, tax cuts, or stimulus payments can increase economic activity and potentially contribute to inflation, particularly when supply can't keep pace with increased demand.
• Monetary policy: Some economists believe that low interest rates and rapid money supply growth can encourage excessive borrowing, spending, and investment.
• Inflation expectations: If consumers and businesses expect prices to keep rising, they may change their spending and pricing decisions in ways that exacerbate inflation.

Cost-push inflation occurs when businesses face higher costs for raw materials, labor, transportation, or other inputs. To protect their profit margins, businesses pass these higher costs on to consumers by raising prices. Common causes of cost-push inflation include:

• Supply shocks: Wars, natural disasters, tariffs, trade wars, labor shortages, or other supply chain disruptions can lead to shipping delays and shortages of critical goods that may lift prices.
• High raw material costs: Rising prices for oil, natural gas, metals, or other commodities can raise businesses' expenses, potentially leading them to pass on those costs to consumers through higher prices.
• Higher labor costs: Rising wages can also increase expenses for businesses, which may pass on those costs to consumers.

The COVID-19 pandemic provides a real-world example of how inflation can develop from multiple sources at the same time. During the pandemic, supply chain disruptions and business closures limited the supply of goods and services in the U.S. economy. At the same time, demand was lifted by stimulus payments, low interest rates, and a forced shift in spending away from services and toward goods. Together, these cost-push and demand-pull pressures contributed to a sustained rise in prices that pushed U.S. inflation to a four-decade high of 9.1% in June 2022.

There is no single, universally accepted measure of inflation. Instead, economists use a variety of gauges to track price changes, helping them build a more complete picture of inflation trends over time. Inflation is typically reported as a percentage change over a specific period, such as month over month or year over year.

Here are some of the most widely tracked inflation metrics.

Economists have also developed a variety of specialized inflation indicators that can provide additional insight into underlying inflation pressures and expectations, including:

• Trimmed mean PCE: This metric excludes the most extreme monthly price changes in goods and services before averaging the remaining components.
• Sticky-price CPI: This gauge divides the components of CPI into either "flexible" (fast changing) or "sticky" (slow changing) categories. By focusing on sticky prices—which are less likely to decline after rising—economists can better identify whether inflation is becoming more entrenched in the economy.
• Commodity price indexes: These track the prices of raw materials and commodities, which can provide a read into cost pressures that businesses may pass on to consumers.
• Consumer inflation expectations: Surveys from the Conference Board, University of Michigan, and the New York Fed include measures of consumers' inflation expectations over the next several years. Since inflation expectations can influence spending and pricing decisions, some economists view surveys as a leading indicator of future inflation.
• Market inflation expectations: The 5-year, 5-year Forward Inflation Expectation Rate reflects the bond market's expectations for the average rate of inflation between five and 10 years from now. Since it focuses on long-term inflation expectations, economists often use it as a gauge of the bond market's confidence in the Fed's ability to ensure price stability.

Inflation can affect investment returns, interest rates, borrowing costs, and the value of money over time—making it an important consideration for many investors.

One of inflation's most direct effects is on purchasing power. Rising prices reduce the quantity of goods and services money can buy—but this applies to investments as well. If inflation rises faster than an investment grows, an investor's real return—their return after accounting for inflation—may be negative.

Inflation can influence interest rates. When inflation rises, central banks may increase interest rates to help slow economic activity and reduce price pressures. Changes in interest rates can affect borrowing costs for consumers and businesses, while also influencing bond prices and the performance of different asset classes.

Inflation can also affect borrowers and lenders differently. Borrowers may benefit when inflation reduces the purchasing power of future loan payments, allowing them to repay debt with dollars that are worth less than when the loan was issued. Lenders, on the other hand, may receive repayments that have less purchasing power than expected if inflation rises faster than anticipated.

Inflation can have a significant impact on investment returns, but its effects vary by asset class. Even within asset classes, inflation can have very different impacts on investments:

• Fixed income: Inflation can erode the purchasing power of bonds' interest payments. For example, if an investor holds a bond that pays 5% interest, but inflation is currently at 4%, their real (inflation-adjusted) return will only be 1%. This applies to certificates of deposit (CDs) and high-yield savings accounts as well. High inflation can also lead to higher interest rates, which can pressure bond prices.
• Stocks: Inflation has a mixed impact on stocks. Companies with strong pricing power may be able to pass on higher production costs to customers, while others can experience margin compression. Certain stock market sectors, such as energy and materials, have historically performed relatively well during periods of elevated inflation, while more growth-oriented sectors like tech may be hurt by inflation as interest rates rise.
• Hard assets: Assets such as real estate, commodities, and precious metals can potentially serve as a hedge against inflation since their values tend to rise alongside prices in the broader economy.
• Inflation-indexed investments: Investors concerned about inflation may consider investments such as Treasury Inflation-Protected Securities (TIPS), which are designed to help preserve purchasing power by adjusting their returns as inflation rises.

Understanding how inflation works and how it is measured may help investors evaluate economic conditions and make more informed financial decisions.