Inflation reduces the purchasing power of each unit of currency, which leads to an increase in the prices of goods and services over time. It's an economics term that means you have to spend more to fill your gas tank, buy a gallon of milk, or get a haircut. In other words, it increases your cost of living.
When you compare the dollar's value today with that in the past, U.S. inflation has reduced the value of the dollar. So as prices rise, your money buys less. For that reason, it can reduce your standard of living over time.
That's why President Ronald Reagan said, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman."
- Inflation exists when prices rise but purchasing power falls over a certain period.
- Demand, supply, and expectations about goods affect inflation rates.
- The Federal Reserve uses monetary policy to manage inflation.
- You can protect yourself from inflation through wise investments.
The inflation rate is the percentage increase or decrease in prices during a specified period, usually a month or a year. The percentage tells you how quickly prices rose during the period at hand. For example, if the inflation rate for a gallon of gas is 2% per year, then gas prices will be 2% higher next year. That means a gallon of gas that costs $2.00 this year will cost $2.04 next year.
The inflation rate is a critical component of the misery index, which is an economic indicator that helps to determine an average citizen's financial health. The other component is the unemployment rate. When the misery index is higher than 10%, it means people are either suffering from a recession, galloping inflation, or both. In other words, either inflation or unemployment is greater than 10%.
If the inflation rate is more than 50% in a month, that's hyperinflation. If inflation occurs at the same time as a recession, that's stagflation. Rising prices in assets like housing, gold, or stocks are called asset inflation.
Causes of Inflation
There are generally two causes of inflation. The most common is demand-pull inflation. That's when demand outpaces supply for goods or services, meaning buyers want the product so much that they're willing to pay higher prices for it.
Cost-push inflation is the second, less common, cause. That's when supply is restricted but demand is not. This happened after Hurricane Katrina damaged gas supply lines. In this case, demand for gasoline didn't change, but supply constraints raised prices to $5 a gallon.
Some people also count built-in inflation as a third cause. This factors people’s expectations of future inflation: When prices rise, labor expects an increase in wages to keep up. But higher wages raise the cost of production, which raises prices of goods and services again. When this cause-and-effect continues, it becomes a wage-price spiral.
Inflation and the CPI
The U.S. Bureau of Labor Statistics (BLS) uses the Consumer Price Index (CPI) to measure inflation. The index gets its information from a survey of 23,000 businesses. It records the prices of 80,000 consumer items each month. The CPI will tell you the general rate of inflation. The BLS chart below uses the CPI to track the inflation rate between 1990 and 2021.
The U.S. inflation rate rose to 6.2% in October 2021—the highest it had been since 1990. Prices for everything from groceries, rent, gas, and medical care to cars, dinner out, and cigarettes climbed during the month of October, causing experts to worry.
CPI is a tool that measures inflation, so the two go hand in hand. They are not completely different from one another.
The Personal Consumption Expenditures price index also measures inflation. It includes more business goods and services than the CPI. For instance, it includes health care services paid for by health insurance. The CPI only includes medical bills paid for directly by consumers.
How Central Banks Manage Inflation
Central banks throughout the world use monetary policy to avoid inflation and its opposite, deflation. In the United States, the Federal Reserve aims for a target inflation rate of 2% year-over-year.
On August 27, 2020, the FOMC announced it will allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while, which can be seen in the October 2021 rate.
The Fed uses the core inflation rate that removes energy and food prices. These prices are set by commodities traders and are too volatile to take into consideration.
How to Protect Yourself
The most powerful way to protect yourself from inflation is to increase your earning ability and income, if possible to do so. A 5% annual raise, or a promotion that nets you a 20% gain, for example, will make inflation less relevant. But if that's not an option, or you are on a fixed income, then you'll need to explore other options.
One way to protect your savings is to invest in the stock market. It has returned around 10% of investments over time. Whether it will do so in the future is unknown, and there's the risk involved in investing in the stock market, too.
Consult with a financial planner before making any financial decisions that may impact your overall financial goals.
If you are looking for a safer way to protect yourself from inflation, consider two instruments you can purchase from the U.S. Treasury.
- Treasury Inflated Protected Securities (TIPS): These pay a fixed rate of interest. Twice a year, the government readjusts the principal in response to changes in the Consumer Price Index, as published monthly by the Bureau of Labor Statistics. This means that, as inflation increases, the value of the bond increases. Although the interest rate doesn't increase, holders get a larger cash payment because the percentage is applied to a larger principal. TIPS do well during inflation but do worse during times of non-inflation or stability. Over the long haul, they do not perform as well as a well-diversified portfolio that includes stocks.
- Series I Bonds: Series I bonds offer a guaranteed fixed rate of return for the life of the bond. They're also affected by a variable rate that is indexed to the CPI and is reset in November and May each year. The return you get for the bond is a composite of its fixed rate and the variable rate in effect at that time. To find out each bond's return, go to the Treasury Department's Savings Bond Calculator.