What is inflation and how does it work?

What is inflation?

Inflation is the increase in prices of goods and services, typically monitored by the Federal Reserve. You’ve likely experienced it without even noticing. Remember how much you paid for a movie ticket when you were growing up, compared to how much you pay now? Or think about your go-to lunch that’s been creeping up in price cent by cent, until a year later you’re spending $1 more for the same salad. Wallet, meet inflation. While a $100 bill will feel, look and even smell the same one year from now, because of inflation, your $100 bill will be worth a little less.

Apart from the ways inflation can affect your day-to-day budget, it also has implications for your long-term planning. For example, if inflation is higher than the interest rate paid on your savings account, your money is actually losing value as time passes. So it’s important to keep an eye on where inflation is and how you’re spending, saving or investing your money.

How is inflation measured?

Inflation is measured by tracking the percentage change within a basket of goods. The percentage change, be it increases or decreases in price, reflects the inflation rate during that period.

Consumer Price Index (CPI)

The CPI measures changes to the cost of goods most consumers purchase. The CPI basket of goods includes common expenses, such as cereal, milk and coffee. The index also uses other common expenses, such as housing, furniture, travel, medical care and recreation.

Because of its focus on typical consumer expenses, the CPI is often used as a go-to tool for inflation measurement, especially when consumer spending or confidence is concerned. There are also subsets of the CPI, including the CPI-U (for urban consumers) and the CPI-E (for older adults).

To track inflation trends over time, you can use the U.S. Bureau of Labor Statistics' (BLS) inflation calculator.

Wholesale Price Index (WPI)

The WPI tracks the price changes of goods before they reach retail consumers. This includes raw materials and bulk items traded directly between businesses. It is different from the CPI, which includes only consumer goods in its calculations.

Measuring the WPI can be helpful for economists and business leaders since it lends insight into potential price increases they may face. This can help business leaders, in particular, adjust their pricing and other elements of their business to maintain financial balance.

Producer Price Index (PPI)

The PPI tracks changes to selling prices over time. The index does this by recording the prices domestic producers receive for their output, such as raw goods or supplies. This index tracks the price received by the producer, rather than the price paid by a business or retail consumer. The PPI helps economists track inflation’s effect on producers rather than commercial or retail consumers.

Why does inflation happen?

Inflation has several causes, including: supply shortages and increased demand, an increase in the cost of a good or service for which there is no replacement available or changes in wages and subsequent price increases. These three common causes are called demand-pull inflation, cost-push inflation and built-in inflation.

Demand-pull inflation

Demand-pull inflation occurs due to supply shortages. If consumers or businesses demand more of something than what’s available, the price of that item rises to meet that demand. For example, if less lumber is available because of high market demand, buyers can expect to pay more for what’s in stock. You may also end up paying more for renovations or construction as well, given a high demand for low stock.

Cost-push inflation

Cost-push inflation occurs when the price of an essential good or service increases when a suitable alternative is unavailable. For example, if oil prices increase, you are likely to pay more per gallon of gasoline since there is no viable alternative source for oil.

Cost-push inflation may also occur if the money supply in circulation is greater than the demand for it. An economy with too much cash in circulation may find that the cash loses value which diminishes a consumer's purchasing power.

Built-in inflation

Built-in inflation refers to the passed-on expenses that buyers pay as a result of increased wages. When employees receive higher pay, their employers often pass these expenses onto their customers. For example, a restaurant that provides employees with a 5% wage increase may increase prices on menu items to ensure they continue making the same profit margin.

Is inflation a bad thing?

It depends. If prices go up from tariffs (taxes on imports and exports) or quotas (a volume target for imports and exports), that can result in goods and services becoming more expensive without a corresponding increase in income and wages. That hurts! In extreme cases, such as during a war or a time of severe economic turmoil, hyper-inflation can cause the value of money to plummet, making it difficult for people to afford basic goods.

But inflation can be a good thing, too. If prices rise as a result of a growing economy, that usually is accompanied by an increase in income and wages, because a strong economy means less unemployment and more competition for labor. So your salad might be more expensive, but you can afford it because your paycheck is a little higher.  It's important to note, however, that wages generally trail inflation leading to potential strain on the wallet in the interim, though this relationship can vary depending on economic conditions.

The takeaway is that inflation is important because it can have an impact on the economy – and that can affect your investment portfolio.

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