What Is the Definition of Inflation?

The Definition of Inflation, Why It Matters, and How To Learn More About It

What Is Inflation?
If you have ever asked the question, "What is inflation?", the simple answer is that inflation is an increase in the cost of living due to rising prices of essentials such as milk, meat, coffee, wheat, clothing, and medical services. Gavin R. Wilson, Photonica, Getty Images

Have you ever asked yourself "What is inflation?" If you have, you aren't alone.  I hear a lot of new investors trying to find a basic definition of inflation as well as attempting to understand why it matters and how it can help or hurt a portfolio.  In the next few minutes, I want to give you a brief overview so you feel better equipped to discuss the topic and research more depending upon how deep you want your knowledge to grow.

The Definition of Inflation

Due to the fact this is a site geared toward investing from a beginner's perspective, I'm going to write about inflation not as a purely economic concept but as a practical, applied concept from the perspective of a portfolio owner. 

Through that lens, inflation refers to a unit of currency depreciating in value so that it takes more currency units to buy the same amount of goods and services as it did in the past.  Although many investors understand this instinctively, they flip it around on its head and, instead, refer to inflation as being an increase in the cost of things that are necessary for humans to live and enjoy life, such as bread, butter, milk, cheese, coffee, oil, shelter, clothing, medical services, chicken, cotton, electronics, shampoo, and prescription eyeglasses.  

In other words, inflation is the phenomenon of your money buying you less stuff.

How Is the Rate of Inflation Measured?

The inflation rate is typically measured by using an something known as an inflation index.

The most popular inflation index in the United States is the Consumer Price Index, which is a basket of goods such as coffee, apparel, etc. The U.S. has enjoyed much lower inflation rates than the rest of the world, in the range of 3% to 4% per annum for the past few decades.  There are many complex causes for this, including the use of the U.S. dollar as the world's reserve currency.

There Are Two Major Causes of Inflation and What Are the Effects on Investors?

Some inflation is caused because a country has printed too much money or experienced financial disaster, causing its currency to plummet.

Other sources of inflation can be higher input or transportation costs such as gas, which makes it more expensive to ship good to retail stores, increasing costs for consumers. The consumers, in turn, have a harder time affording stuff such as toilet paper, toothpaste, jeans, paper, cars, lamps, furniture… you get the idea. At this point, the consumers demand pay raises at their companies, possibly pressuring profits further, which can lead to additional price increases, and the cycle begins. This is when economists say that inflation has become “embedded” in the economy. For more information, read the article What Causes a High Inflation Rate?, in which I walk you through the two sources of a high inflation rate in more detail.

You may also want to read, What Are the Effects of Inflation? to understand how inflation can hurt, or in rarer cases, help, your net worth.  The latter I touch upon in more detail in an article called Profiting from Inflation in which I explain how certain types of businesses have some degree of natural protection from inflation, allowing you to maintain your purchasing power if you invest in them.

Although not always possible, it’s the firms that sell things such as brand name cornflakes or baby powder - think Kellogg’s or Johnson & Johnson - that have the easiest time passing on higher prices to customers and recouping their investment.  Frequently, but not always, these firms are also blue chip stocks, which have other benefits, as well.

One of the biggest dangers of inflation from the perspective of the investor is owning fixed income securities, such as bonds.  When you lend money for long periods of time, you are effectively shorting the fiat currency in which that loan is denominated.  This means that your corporate bond holdings, municipal bond positions, and even, to a lesser degree, your certificates of deposit and money markets lose buying power with each passing year, even if it looks like you have more dollars from the interest income.

 This can create a strong disincentive to saving money by encouraging investors and consumers to spend money now as their wealth buys fewer and inferior goods over time.  It can also cause investors to make dumb mistakes, taking on too much risk as they seek higher returning opportunities that ultimately lead to major losses.  

There are a few potential solutions for the fixed income investor in this scenario.  One option is to buy Series I savings bonds. These bonds are guaranteed by the United States Government to never lose money and the interest rate is based upon a combination fixed rate and inflation rate that changes as prices increase or decrease.  Another investment worth considering are called TIPS or, "Treasury Inflation-Protected Securities".  These are special types of U.S. Treasury Bonds that adjust the maturity value for inflation and deflation based on changes in the Consumer Price Index.

Read More About Inflation and Your Investments

To learn more about this topic, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as:

It's certainly a fascinating topic and one that will become important again, eventually, even if it seems like a distant memory at the moment.  It's also fun to learn different analysis techniques, such as how to estimate inflation expectations by examining Treasury Bond and TIP Spreads.  For me, as someone who overwhelmingly prefers long-term equity investments, I tend to opt for high quality businesses with high returns on capital and strong pricing power.  It is entirely possible inflation could slaughter the economic returns of investors who owned shares of a steel mill.  On the other hand, it isn't likely to have a hugely detrimental effect on owners of a company like McDonald's, Diageo, or Coca-Cola.