In the simplest terms possible, inflation refers to the increase in costs for goods and services. This increase can be gradual or sudden, depending on other economic factors. Inflation is a complex concept that's determined by a multitude of factors, but it is possible to identify a few of the primary price-movers.
It's important to understand inflation because it can affect everything from the price you pay for a gallon of milk to the price you pay for a share of common stock. Those with bond investments and other forms of fixed income face extra risks related to rising inflation rates.
Overlooking inflation can pose a powerful threat to your journey to financial independence. In extreme cases, it can keep you from retiring in comfort, and it can even affect your ability to meet your day-to-day living expenses.
The 2 Types of Inflation
Economists with the Federal Reserve typically categorize instances of rising inflation rates into two types: "demand-pull" inflation and "cost-push" inflation. While these have been identified as the two primary types of inflation, they rarely occur independently, nor are they isolated from the impacts of other economic events.
High demand-pull inflation is caused by a rapid increase in demand without an equally rapid increase in productivity or supply. An example would be if a country's central bank floods the economy with more money and salaries rise. All else being equal, the extra money in consumers' pockets will increase their desire to buy things. In other words, demand rises. If supply can't keep up with demand, then the price for those goods and services in demand will rise.
Perhaps the most notorious example of this took place in Germany during and after World War I. The government at the time tried to combat a souring economy by printing more money. As more bills were printed, the value of the currency decreased, and the cost of goods increased. At one point during this period of inflation, a single U.S. dollar was worth 4.2 trillion German marks.
As more money floods the economy, the relative income of different professions isn't likely to change. Lawyers who made $100,000 before the inflation increase, for example, might be making $300,000 afterward.
In the other scenario, high rates of inflation are driven by increasing costs on the supply side of the economy. If it costs more to buy the materials to make a product, those costs are often passed onto consumers in the form of higher prices. All kinds of factors can hike the price of these raw materials. Whatever the cause, as the cost for basic raw materials increases, prices across the entire economy rise.
For a real-world example of cost-push inflation, the Federal Reserve often points to the so-called Great Inflation of the '60s and '70s. The inflation rate in the U.S. climbed as high as 12% during this time. Aspects of this were driven by demand-pull inflation, but the '70s also saw the prices of food and energy increase, which caused a rapid increase in cost-push inflation.
As the price of food rose, the cost of living inevitably rose—everyone needs to eat. Likewise, the price of energy sources like oil affects the broader economy. While you might only think about gas prices when you fill up your car, fuel prices affect anything that's transported to consumers. Whether it's an electronic device assembled in China or a pair of shoes stitched in Italy, fuel costs will be included in the price a middle-class consumer pays at a Chicago-area mall.
All consumers feel the impact of inflation, so the government pays close attention to inflation rates. There are many ways to measure inflation, but two of the most commonly referenced metrics in the U.S. are the Consumer Price Index (CPI) and the Personal Consumption Expenditures price index (PCE).
The CPI is calculated by the Bureau of Labor Statistics. It measures changes in the prices an average urban consumer pays for a representative basket of goods. This figure can be further specified to measure inflation in certain sectors or for certain consumers. This is a popular metric to follow because it is used to adjust Social Security payments and some kinds of financial contracts.
The PCE is measured by the Bureau of Economic Activity. It's similar to the CPI, but it strives to capture a wider range of consumer activity and give insight into changing behavior. The Federal Reserve references the PCE most often and states inflation targets in terms of PCE.