Inflation: How It's Measured and Managed

Why inflation is one of the Fed's top priorities

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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. It increases your cost of living.

When you compare the current dollar value with that of the past, U.S. inflation has reduced its purchasing power. So as prices rise, your money buys less— reducing your standard of living over time.

Key Takeaways

  • Inflation exists when prices rise but purchasing power falls over a period of time.
  • 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

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 that period. Gas prices will be 2% higher next year if the inflation rate for a gallon of gas is 2% per 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. People are either suffering from a recession, struggling with inflation, or both when the misery index is higher than 7%.

There are a number of different types of inflation. Hyperinflation is when prices rise more than 50% in one month. It's stagflation if inflation occurs at the same time as a recession. 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. 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 2005. Demand for gasoline didn't change in this case, 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. This raises prices of goods and services again. It becomes a wage-price spiral when this cause-and-effect continues.

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 since 1990.

CPI is a tool that measures inflation, so the two go hand in hand. They're not completely different from each other.

The Personal Consumption Expenditures price index also measures inflation. It includes more business goods and services than the CPI, such as 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.

The FOMC announced on August 27, 2020, that it will allow a target inflation rate of more than 2% if that would help ensure maximum employment. It still seeks a 2% inflation over time, but it's 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, which doesn't account for energy and food prices. These prices are set by commodities traders and are too volatile to take into consideration. 

In March 2022, the FOMC began responding to the high inflation rate by raising the federal funds rate for the first time since 2018.

How To Protect Yourself 

The most powerful way to protect yourself from inflation is to increase your earning ability and income, if it's possible to do so. A 5% annual raise, or a promotion that nets you a 20% gain, would make inflation less relevant. You'll have to explore other options if that's not possible, or if you're on a fixed income.

One way to protect your savings is to invest in the stock market. It's returned around 10% of investments over time. But whether it will do so in the future is unknown, and there's risk involved in investing in the stock market, too.

Consult with a financial planner before making any decisions that may impact your overall goals.

Consider two instruments you can purchase from the U.S. Treasury if you're looking for a safer way to protect yourself from inflation:

  • Treasury Inflated Protected Securities (TIPS): These pay a fixed rate of interest. The government readjusts the principal in response to changes in the Consumer Price Index, as published monthly by the Bureau of Labor Statistics, twice a year. The value of the bond increases as inflation increases. The interest rate doesn't increase, but 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. They don't perform as well over the long haul 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. Go to the Treasury Department's Savings Bond Calculator to find out each bond's return.

Frequently Asked Questions (FAQs)

Whom does inflation benefit?

Inflation benefits those who hold assets, such as stocks and commodities, with values that tend to rise with inflation. Those with fixed-rate mortgages also benefit by maintaining a lower interest rate as other rates go up with inflation.

How does inflation affect interest rates?

Inflation tends to drive interest rates up. Lenders may naturally raise rates to offset the devaluation of the dollar, and the Federal Reserve will raise target rates, as it did in the May FOMC meeting, in order to slow down inflation.

How does inflation affect the economy?

Inflation's effect on the economy depends on its relative severity and predictability. Economists prefer a stable, low level of inflation that encourages steady levels of spending and economic growth. Consumer spending can spike too rapidly if inflation levels get too high or if they fluctuate sporadically, causing supply chain pressures and further driving up inflation.

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