Inflation is a fundamental economic concept that affects everyone in the economy. When inflation occurs, each unit of currency buys fewer goods and services than it did previously, effectively reducing consumers' purchasing power.
The most commonly cited inflation measure in the U.S., the CPI tracks the average change in prices paid by urban consumers for a market basket of consumer goods and services. It includes food, housing, apparel, transportation, medical care, recreation, education, and other goods and services.
The PCE price index is the Federal Reserve's preferred inflation measure. It captures a broader range of consumer expenses and adjusts for changing consumer behavior. The PCE typically shows a lower inflation rate than the CPI.
The PPI measures average changes in selling prices received by domestic producers for their output. It can be an early indicator of CPI inflation, as producer cost increases are often passed on to consumers.
Occurs when aggregate demand exceeds aggregate supply, causing prices to rise. This can happen when consumer spending increases due to factors like low unemployment, wage growth, or easy access to credit.
Results from increases in production costs, such as raw materials or wages, which suppliers pass on to consumers through higher prices. Oil price shocks are a classic example of a cost-push inflationary force.
Also called wage-price spiral, this occurs when workers demand higher wages to keep up with rising costs of living, and businesses raise prices to cover higher wage costs, creating a self-reinforcing cycle.
Generally considered healthy for a growing economy. Central banks in developed countries typically target inflation around 2%.
Erodes purchasing power significantly and creates economic uncertainty. It can lead to higher interest rates, reduced business investment, and decreased standards of living.
Extreme inflation that can destabilize economies and destroy savings. Historical examples include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in recent years.
The opposite of inflation, deflation is a decrease in the general price level. While lower prices may seem beneficial, deflation can lead to reduced spending, lower wages, increased debt burden, and economic contraction.
Inflation erodes the value of cash and savings held in low-interest accounts. If your savings account pays 1% interest during a period of 3% inflation, your money is losing purchasing power at a rate of 2% annually.
Bondholders and those relying on fixed payments suffer during inflation because the future payments become worth less in real terms.
Inflation can benefit borrowers with fixed-rate loans, as they repay their debt with money that's worth less than when they borrowed it. However, inflation often leads to higher interest rates for new loans.
Assets like real estate, commodities, and certain stocks can serve as inflation hedges because their values tend to rise with inflation.
Treasury Inflation-Protected Securities (TIPS) and I Bonds adjust in value or interest rate based on inflation measures, directly protecting against inflation.
Investments in real estate, commodities, and infrastructure can provide inflation protection as their values typically increase with rising prices.
Stocks, particularly of companies that can pass on higher costs to customers, have historically outpaced inflation over long periods.
Investments that adjust their payments with inflation or interest rates, such as floating-rate bonds or dividend-growing stocks, can help maintain purchasing power.