Inflation is a measure of how fast prices of goods and services are rising. If inflation is occurring, leading to higher prices for basic necessities such as food, it can have a negative impact on the overall economy.
Inflation can occur in nearly any product or service, including need-based expenses such as housing, food, medical care, and utilities, as well as want expenses, such as cosmetics, automobiles, and jewelry. Once inflation becomes prevalent throughout an economy, the expectation of further inflation becomes an overriding concern in the consciousness of consumers and businesses alike.
Central banks of developed economies, including the Federal Reserve in the U.S., monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.
Inflation can be a concern because it makes money saved today less valuable tomorrow. Inflation erodes a consumer's purchasing power and can even interfere with the ability to retire. For example, if an investor earned 5% from investments in stocks and bonds, but the inflation rate was 3%, the investor only earned 2% in real terms. In this article, we'll examine the fundamental factors behind inflation, different types of inflation, and who benefits from it.
- Inflation is a measure of the rate of rising prices of goods and services in an economy.
- Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages.
- A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product.
- Some companies reap the rewards of inflation if they can charge more for their products as a result of the high demand for their goods.
What Drives Inflation
There are various factors that can drive prices or inflation in an economy. Typically, inflation results from an increase in production costs or an increase in demand for products and services.
Cost-push inflation occurs when prices rise because production costs increase, such as raw materials and wages. The demand for goods is unchanged while the supply of goods declines due to the higher costs of production. As a result, the added costs of production are passed onto consumers in the form of higher prices for the finished goods.
One of the signs of possible cost-push inflation can be seen in rising commodity prices such as oil and metals since they're major production inputs. For example, if the price of copper rises, companies that use copper to make their products might increase the prices of their goods. If the demand for the product is independent of the demand for copper, the business will pass on the higher costs of raw materials to consumers. The result is higher prices for consumers without any change in demand for the products consumed.
Wages also affect the cost of production and are typically the single biggest expense for businesses. When the economy is performing well, and the unemployment rate is low, shortages in labor or workers can occur. Companies, in turn, increase wages to attract qualified candidates, causing production costs to rise for the company. If the company raises prices due to the rise in employee wages, cost-plus inflation occurs.
Natural disasters can also drive prices higher. For example, if a hurricane destroys a crop such as corn, prices can rise across the economy since corn is used in many products.
Demand-pull inflation can be caused by strong consumer demand for a product or service. When there's a surge in demand for a wide breadth of goods across an economy, their prices tend to increase. While this is not often a concern for short-term imbalances of supply and demand, sustained demand can reverberate in the economy and raise costs for other goods; the result is demand-pull inflation.
Consumer confidence tends to be high when unemployment is low, and wages are rising—leading to more spending. Economic expansion has a direct impact on the level of consumer spending in an economy, which can lead to high demand for products and services.
As the demand for a particular good or service increases, the available supply decreases. When fewer items are available, consumers are willing to pay more to obtain the item—as outlined in the economic principle of supply and demand. The result is higher prices due to demand-pull inflation.
Companies also play a role in inflation, especially if they manufacture popular products. A company can raise prices simply because consumers are willing to pay the increased amount. Corporations also raise prices freely when the item for sale is something consumers need for everyday existence, such as oil and gas. However, it's the demand from consumers that provide corporations with the leverage to raise prices.
Built-In Inflation and Rising Wages
Built-in inflation occurs when enough people expect inflation to continue in the future. As the price of goods and services rises, people may come to believe in a continuous rise in the future at a similar rate. Because of these shared expectations, workers may start to demand higher wages in order to anticipate rising prices and maintain their standard of living. Increased wages would result in higher costs for businesses, which may pass those costs on to consumers. Higher wages also increase consumers' disposable income, increasing the demand for goods that can push prices even higher. A wage-price spiral can then be set in place as one factor feeds back into the other and vice-versa.
The Housing Market
The housing market, for example, has seen its ups and downs over the years. If homes are in demand because the economy is experiencing an expansion, home prices will rise. The demand also impacts ancillary products and services that support the housing industry. Construction products such as lumber and steel, as well as the nails and rivets used in homes, might all see increases in demand resulting from higher demand for homes.
Expansionary Fiscal and Monetary Policy
Expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital improvements, employee compensation, or new hiring. Consumers may purchase more goods as well. The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases.
Just as expansionary fiscal policy can spur inflation, so too can loose monetary policy. Expansionary monetary policy by central banks can lower interest rates. Central banks like the Federal Reserve can lower the cost for banks to lend, which allows banks to lend more money to businesses and consumers. The increase in money available throughout the economy leads to more spending and demand for goods and services.
Monetarists understand inflation to be caused by too many dollars chasing too few goods. In other words, the supply of money has grown too large. According to this theory, money's value is subject to the law of supply and demand, just like any other good in the market. As the supply grows, the value goes down. If the value of money goes down, its purchasing power drops and things become relatively more expensive.
This quantity theory of money (QTM) can be summarized in the equation of exchange, which states that the money supply, multiplied by the rate at which money is spent per year (the velocity of money), equals the nominal expenditures in the economy: MV = PQ. P (prices) can thus go up as the money supply increases, and/or the velocity of money increases (given a constant quantity of goods in the economy).
Money can also lose value due to a general lack of confidence or trust in the issuer of the money. In this case, hyperinflation may even set it as the money is seen as lacking value altogether.
Measures of Inflation
Consumer Price Index (CPI)
There are a few metrics that are used to measure the inflation rate. One of the most popular is the Consumer Price Index (CPI), which measures prices for a basket of goods and services in the economy, including food, cars, education, and recreation. Changes in the prices of this basket, therefore, approximate changes in prices across the whole economy. The CPI is often the economic indicator of choice used for measuring inflation.
While the CPI does measure the price changes for retail goods and other items paid by consumers, it does not include things like savings and investments, and will often exclude spending by foreign visitors.
In April 2022, the Consumer Price Index increased 0.3% on a seasonally adjusted basis. But when compared to the year prior, the full index increased 10.8%, making it the largest year-over-year increase since November 1980.
Producer Price Index (PPI)
Another measure of inflation is the Producer Price Index (PPI), which reports the price changes that affect domestic producers. The PPI measures prices for fuel, farm products (meats and grains), chemical products, and metals. If the price increases that cause the PPI to spike get passed onto consumers, it will be reflected in the Consumer Price Index.
PPI measures inflation from the viewpoint of the producers; the average selling price they receive for their output over a period of time. Meanwhile, CPI measures prices from the standpoint of the consumer.
The U.S. Bureau of Economic Analysis (BEA) uses the gross domestic product (GDP) deflator (also known as the GDP price deflator) as an additional indicator of the level of U.S. inflation. The GDP deflator measures the aggregate prices of all goods and services produced by the entire nation; it encompasses both the CPI and PPI statistics.
Personal Consumption Expenditures (PCE) Price Index
The personal consumption expenditures (PCE) index is another measure of inflation that tracks price changes in the amount spent on consumer goods and services exchanged in the U.S. economy. The PCE Price Index is composed of a broad range of expenditures that is far larger than the basket of goods used in the CPI, and it is weighted by data provided by regular business surveys, which tend to be more reliable than the consumer surveys used by the CPI
In 2012, the PCE Price Index became the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions.
How to Protect Against Inflation
High inflation is generally a negative, hurting both consumers and businesses. There are, however, some ways to protect against inflation:
- Lock in low fixed interest rates: A 30-year mortgage at a low fixed interest rate is protected against inflation. Look to borrow when interest rates are low and consider refinancing when rates drop
- Invest in stocks: Stock markets tend to do relatively better than bonds in a high-inflation environment, as many companies end up passing on higher costs to consumers, which protects profits. Firms that produce commodities or staple goods are often good bets. Bonds, on the other hand, see their prices go down as interest rates rise along with inflation.
- Buy inflation-protected securities: Some financial products are linked to inflation (often via changes in CPI), such as Treasury Inflation-Protected Securities, or TIPS, which adjust in price to offset inflation. Some permanent life insurance products and annuities may also have an option to be adjusted for inflation, often in the form of a cost of living adjustment (COLA) rider.
- Save at high interest rates: Use high interest rates to save money in money market accounts or CDs at more favorable yields. Note, however, that if the yield proves to be lower than the rate of inflation, you'll still lose buying power.
- Buy an inflation hedge: Certain assets like gold and real estate are thought to be good hedges against inflation, increasing in value along with a general rise in prices.
- Own rental real estate: When inflation hits, landlords can often raise the rent to keep pace. If you have an income property with a fixed-rate mortgage, this can greatly improve your bottom line.
What Causes Inflation?
Economists have identified several possible causes for inflation. Cost-push inflation is the decrease in the aggregate supply of goods and services stemming from an increase in the cost of production. An increase in the costs of raw materials or labor can contribute to demand-pull inflation. Expectations of inflation that prompt higher wages leading to higher costs are theorized as built-in inflation. Supply or demand shocks can also cause higher prices, as can loose fiscal and monetary policy.
Who Benefits From Inflation?
In general, inflation benefits borrowers who have lower fixed interest rates and owners of assets that rise along with inflation. The relative costs of servicing these debts becomes less expensive with inflation.
Investors can enjoy a boost if they hold assets in markets affected by inflation. For example, those who are invested in energy companies might see a rise in their stock prices if energy prices are rising. Often, value stocks perform better than growth stocks during inflationary periods.
Who Is Hurt by Inflaton?
Inflation tends to harm savers and lenders the most. Savers see their cash deposits eroded of purchasing power, while those who loaned money at lower fixed interest rates are stuck with less valuable loans until they mature.
Consumers are also harmed by inflation as goods become more expensive. Lower-income consumers can be hurt the most as these people tend to spend a higher proportion of their income overall and on necessities than those with higher incomes, and so have less of a cushion against the loss of purchasing power inherent in inflation.
Can Companies Benefit From Inflation?
Some companies reap the rewards of inflation if they can charge more for their products as a result of a surge in demand for their goods. If the economy is performing well and housing demand is high, home-building companies can charge higher prices for selling homes.
In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in production costs.
Also, business owners can deliberately withhold supplies from the market, allowing prices to rise to a favorable level. However, companies can also be hurt by inflation if it's the result of a surge in production costs. Companies are at risk if they're unable to pass on the higher costs to consumers through higher prices. If foreign competition, for example, is unaffected by the production cost increases, their prices wouldn't need to rise. As a result, U.S. companies might have to eat the higher production costs, otherwise, risk losing customers to foreign-based companies.
The Bottom Line
Inflation occurs when prices rise in an economy and/or the purchasing power of money loses value. Economists have identified several possible causes for inflation from rising wages to increased aggregate demand to an increase in the supply of money. In 2022, inflation rates in the U.S. and around the world rose to their highest levels since the early 1980s. While there is no single reason for this rapid rise in global prices, a series of events worked together to boost inflation in its latest cycle, including the repercussions of the COVID-19 pandemic, Russia's unprovoked invasion of Ukraine, and the shock to energy and food prices that resulted.