What is Inflation and How Does It Affect Me?

What is Inflation Key takeaways

• Because of inflation, a dollar today only buys about 87% of what it could buy in 2020.
• The Federal Reserve manipulates the money supply and interest rates to try to keep inflation at around 2%.
• There are three major types of inflation: demand-pull inflation, cost-push inflation and built-in inflation

When the cash in your wallet loses purchasing power, that’s called inflation. Economies work best when there’s a balance of supply (goods and services) and demand (people wanting to buy those goods and services). Since the 1990s, the U.S. economy has been mostly balanced, with moderate inflation running between 1.5% and 3% a year.

In 2022, our economy was emerging from an economic slowdown resulting from COVID-19, and it was coming out hot. Americans were ready to get back to work and spend. At the same time, the federal government boosted spending by trillions of dollars. Consumers used those dollars to purchase goods and services, but production wasn’t fully back online to meet the supply. Meanwhile, wages, oil prices and production costs were rising—and being passed along to consumers.

When that happened, inflation accelerated. In 2020, the rate of inflation, as measured by the consumer price index (CPI) was 1.23%. At the end of 2022, it had grown to 8%.

High inflation weighs on individuals, families, employers, and the economy as a whole. As consumers, it’s important for us to understand the causes and effects of inflation, how it impacts us and how we can manage it in our personal finances.

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Causes of inflation

Many factors contribute to inflation, but the main one is the money supply in the economy, which is controlled by central banks. John Taylor, an economist at Stanford University, says this is a key misunderstanding people have about inflationary pressures.

“Monetary policy is a major cause of the increase in inflation,” he says in a September 2022 article. “The Federal Reserve has kept its interest rate—the federal fund rate—much lower than in other recent years.” The Fed has been increasing the federal funds rate in order to beat inflation, and its chairman, Jay Powell, expects it to top 5% in 2023. For comparison, during the pandemic in 2020, the Fed cut the rate to effectively 0 to support the economy.

Three types of inflation

Economists describe 3 major types of inflation: demand-pull inflation, cost-push inflation and built-in inflation.

• Demand-pull inflation. When the demand for goods and services in the economy strongly outweighs the supply, prices go up. In response to the demand, companies hire more people to increase output, increasing employment and creating more demand among consumers. Companies may raise prices in expectation of higher costs in the future.
• Cost-push inflation. When the aggregate supply of goods and services drops due to increases in the cost of labor, capital, and raw materials, it’s cost-push inflation. Companies raise prices to maintain their profit margins or they decrease production. Not all economists buy into the concept of cost-push inflation, attributing price increases to greater demand and money supply.
• Built-in inflation. When workers expect their salaries or wages to increase as prices for goods and services rise to maintain their standard of living, it’s built-in inflation. It then becomes a “normal” aspect of the economy because of inflation expectations and the price/wage spiral.

Effects of inflation

Most economists believe that moderate inflation benefits a healthy economy because of its predictability. For example, individuals can confidently create spending and investment plans, while companies are able to forecast prices and wages.

The Federal Reserve wants to control inflation so that it increases about 2% year over year. It can manipulate the money supply and interest rates to try to reach that goal.

But inflation is a double-edged sword, with positive and negative effects even in a high-inflation environment. Let’s look at a few of them.

Positive effects

They may not be obvious—especially with higher prices for basics like food and fuel—but inflation has a few upsides.

• You might make more money. Employers often must increase wages as demand for their goods and services rises. Wages are expected to rise an average of 4% in 2023. Social Security recipients are receiving an increase of 8.7% in benefits in 2023. Both of those should encourage consumer spending and investment.
• You might see a better return on savings. Many high-yield savings accounts, which are FDIC insured, are now paying more than they have in a decade, with some interest rates reaching upwards of 3%. Some short-term U.S. Treasury yields are now at or near the 4% range—and they’re virtually risk-free.
• Your mortgage may become a better deal. Fixed-rate, 30-year loans make up nearly $11 trillion worth of America’s $15 trillion in debt. If your income goes up, you may be paying less for your mortgage as a percentage of monthly income. Plus, a 2% or 3% mortgage looks very favorable when mortgage interest rates are north of 5%. Student loans also have a fixed interest rate.

Negative effects

We see the downsides of high inflation all around us, from rising prices at the grocery store to lower stock market returns. As inflation rises:

• Your purchasing power erodes. A dollar today only buys about 87% of what it could buy in 2020. In some sectors, notably food, the loss of buying power is even more extreme—and it’s not expected to get much better in 2023.
• You pay more for loans. Higher interest rates on cars and credit cards make it more difficult to buy goods and services on credit. Higher mortgage interest rates make for higher monthly payments, which has the effect of kicking more people out of the housing market.
• The future feels uncertain. What will happen with economic growth? Will there be deflation, or even a recession? The Conference Board expects a mild recession in 2023, but no one can say how this current inflationary period will play out. The financial markets, in particular, hate uncertainty, so the major stock indexes were off by double digits in 2022. That means vast sums of capital were withdrawn from many businesses. It’s also likely your 401(k) or IRA took a hit, too. What does that mean for your retirement? So many questions, and just not enough answers.

Measuring inflation

When we hear on the news that “inflation is up,” what does that mean? There are a few different price indexes by which inflation is measured.

• Consumer Price Index (CPI). This measures the average change in the prices paid by urban consumers for a market basket of goods and services. The U.S. Bureau of Labor Statistics (BLS) publishes the data monthly.
• Producer Price Index (PPI). Also published by the BLS, the PPI is a measure of inflation at the wholesale level, tracking the average change in the prices domestic producers receive for their output. The PPI is different from the CPI, which measures the changes in consumer prices for goods and services.
• Personal Consumption Expenditures Price Index (PCEPI). Compiled by the U.S. Bureau of Economic Analysis, the PCEPI allows us to see how well the overall economy is faring from month to month because it captures how consumers spend and change their buying habits in response to price changes.

What is inflation for you

Rising prices don’t mean the same thing for everyone. You have a personal inflation rate based on where you live and how you spend your money. To lower your “me-flation” rate, concentrate on managing your expenses in areas where prices rise fastest: food, energy, and housing.

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