What is Inflation?
Inflation is the increase in the price of goods and services over time and the resulting reduction in the purchasing power of a given currency.
Inflation decreases the value of a dollar (or other currency), and as inflation rises, your money can buy less and less. Economists measure the increase or decrease in inflation over time. This measurement is known as the inflation rate. We see the effect of inflation in many areas of our lives. Some of these effects include price increases for housing, food, fuel, and consumer goods. While there may be some benefits to moderate inflation, consumers tend to focus most on the fact that it means their money can’t go as far as before.
For a real-world example of inflation, let’s look at the price of gasoline. According to the U.S. Bureau of Labor Statistics, the price of gas saw an inflation rate of about 3.10% per year between the years 2000 and 2019. So a tank of gas that cost $20 in 2000 is going to cost you more than $35 in 2019. That’s a pretty hefty increase. The inflation rate for gas during that time period was about 1% higher than the overall rate of inflation.
Inflation is like a leak in your money bucket...
If the inflation rate is low, the leak is smaller. If the inflation rate is high, the leak is bigger. The more leakage there is, the less your money is worth — and the more of it you’ll need to buy the same basket of goods and services a year from now.
There are three primary causes of inflation, each known by a different name.
The demand-pull effect occurs when the demand for goods and services outpaces the supply. Buyers are willing to pay more, and so the suppliers increase the price accordingly. This creates demand-pull inflation.
The cost-push effect occurs when the cost to produce a product increases. This might include an increase in labor costs or the costs of the raw material to produce a product.
When the costs at one end of the supply chain increase, those costs typically trickle down to consumers. This creates cost-push inflation.
The final type of inflation, which occurs in a cycle, is built-in inflation. As the price of goods and services goes up, wages have to go up, too. As wages increase, so does the cost of doing business. So, prices must increase as well.
This creates a cycle of built-in inflation.
Each year, economists determine what the inflation rate was for the previous 12 months. Each year, we can expect this number to be different based on what is happening in the economy. In the past several years, the rate of inflation has stayed relatively consistent.
For example, according to the Federal Reserve Bank of Minneapolis, the inflation rate in 2017 was 2.1% — meaning it would cost approximately 2 pennies more to buy the same basket of goods and services at the end of the year compared to at the beginning of the year.
The inflation rate in 2018 was 2.4%. The inflation rate for 2019 is currently estimated to be approximately 1.8%.
The numbers we’ve discussed apply to the dollar in general, but inflation rates can also vary from state to state and from city to city.
While the inflation rate has stayed relatively consistent over the past few years in the United States, that has not always been the case.
History has seen the U.S. inflation rate rise to 14% in 1947. It has fallen by as much as 11% in 1921. When inflation is negative — that is, when a dollar or other currency can suddenly buy more goods and services than before — that is known as deflation. For the last half-century, we have generally seen inflation, not deflation, in prices.
Considerable increases in inflation are known as hyperinflation.
A significant event in the economy usually causes a bout of significant inflation or deflation.
Periods of inflation and deflation will often correlate with bull and bear markets. A bull market is more likely to see inflation; a bear market is more likely to see deflation.
There are two primary ways of tracking inflation: one is focused on consumers, the Consumer Price Index (CPI); the other is focused on wholesalers, a Wholesale Price Index (WPI) or Producer Price Index (PPI).
The U.S. Bureau of Labor Statistics uses what is called the CPI to measure inflation. It measures the CPI by looking at the price increases (or decreases) of goods and services across a variety of industries. The major industries included in this calculation are food and beverages, housing, apparel, transportation, education & communication, recreation, medical care, and other goods and services.
The Bureau of Labor Statistics has used CPI to track and report on the cost of living since 1913.
A Wholesale Price Index (WPI) is like the Consumer Price Index in that it tracks the change in prices of goods. However, rather than tracking price at the consumer level like CPI, WPI tracks changes at the wholesale level. It follows the price of goods sold in bulk from one company to another, not from a company to the consumer.
The United States used a Wholesale Price Index until 1978. After that, it changed the name to the Producer Price Index (PPI). The calculation for PPI is similar to WPI, but it includes the prices of services as well as goods.
The Producer Price Index is tracked by the Bureau of Labor Statistics and reported monthly.
To find out the inflation rate for any given year, you can use the U.S. Bureau of Labor Statistics (BLS) CPI Inflation Calculator. This calculator will tell you the change in the value of a dollar over a specified period.
The BLS uses the following calculation to determine the rate of inflation:
Inflation Increase = Final CPI Index Value / Initial CPI Value
Savings and retirement accounts can take a hard hit from inflation.
Here’s an example for you:
Let’s say you put $100,000 into a savings account. And let’s say that 20 years from now, the cumulative rate of inflation is 50%. If your savings have not also increased by 50%, you will have lost money in real-dollar terms.
One way of hedging against inflation is to be invested in the stock market. This is because as inflation increases, the stock market tends to rise in value as well. (Investment returns are never guaranteed; all investments always carry risks.)
Of course, the economy could also experience deflation over the medium to long term — meaning the money in your savings account would be worth more in real terms — and/or the stock market could decline over a long period, though this is historically rare.
Another way to invest in protecting yourself from inflation is to invest in Treasury Inflation-Protected Securities (TIPS). TIPS are low-risk bonds that are indexed to inflation, meaning you aren’t losing money as inflation rises.
Most of us only think of inflation as a bad thing, because it means things are getting more expensive. And while there are downsides to inflation, it can have upsides, too.
First of all, a moderate amount of inflation is a sign of economic growth. It’s normal that when the economy is healthy, inflation rises a bit.
There’s another benefit to inflation, one that most consumers would probably find to be a good thing. As the value of a dollar decreases, so does the value of debt. Incomes typically rise as inflation rises, meaning your monthly debt payments can take up a smaller part of your income.
The downsides of inflation are perhaps more readily apparent. Inflation decreases the value of a dollar and makes goods and services more expensive.
While these rising costs are always inconvenient, they can become especially dangerous when incomes aren’t rising at the same rate as inflation.
Inflation can also be detrimental to savings and retirement accounts. The money you’ve saved isn’t worth as much as when you earned it, which might mean the money doesn’t go as far when you retire.
What is the Stock Market?
What are bull and bear markets?
What is an IPO (Initial Public Offering)?
What is an Exchange Traded Fund (ETF)?
What is a Bond?
What is a Dividend?
What is Macroeconomics?
Macroeconomics is the study of an overall economy — for example, of a country, a continent, or the entire world.
What is Due Diligence?
Due diligence is the process of investigating something, usually a potential investment or plan for the future, to ensure that you know all of the details and risks before making a commitment.
What is Deflation?
Deflation is the decrease in the price of goods and services over time, which results in an increase in the purchasing power of a currency.
What is the Dow?
Born in 1896, the Dow Jones Industrial Average (aka “the Dow”) is an index of 30 big and prestigious public companies — and it’s used to measure the stock market in general.
What is Mutually Exclusive?
Mutually exclusive refers to the relationship between two or more events that cannot occur at the same time.