What Is Inflation?

Economists measure inflation by tracking the changes in the prices of goods and services over time using the Consumer Price Index (CPI) and the Producer Price Index (PPI). The CPI focuses on the cost of a basket of commonly purchased consumer goods and services, including essentials like food, housing, and healthcare, while the PPI examines the average change in selling prices received by domestic producers for their goods. These indexes provide crucial information about how prices are changing for both importers and consumers. 

For example, if a loaf of bread was $2 one year and $2.10 the next year, that would represent a 5% increase.

A moderate level of inflation, usually around 2% annually, is considered a sign of a growing economy because it encourages spending and investment rather than hoarding cash. However, if inflation rises too quickly, it can erode purchasing power, making everyday expenses like groceries and rent prohibitively expensive.

Inflation occurs due to several factors, often categorized into three main types:

The effects of inflation can be seen in multiple areas of the economy but are most obviously seen in reduced consumer purchasing power. As prices rise, the same amount of money buys fewer goods and services. For example, your $50 grocery budget that once covered a week’s worth of items may, over time, only buy a few essentials. This decline in purchasing power can strain household finances, especially for those with fixed incomes like senior citizens.

Controlled levels of inflation can be healthy for the economy, but when inflation gets too high or remains uncontrolled for long periods of time, it erodes consumer and business confidence. Uncontrolled inflation increases uncertainty, making it harder for businesses to plan for the future or for individuals to save for long-term goals like retirement. This results in add-on effects of rising prices and reduced spending, both of which can lead to economic decline.

To combat rising inflation, central banks often raise interest rates, making borrowing more expensive. While this can help cool the economy and reduce inflationary pressures, it may also slow economic growth and impact asset valuations. In this balance of interest and inflation rates, it’s crucial that lawmakers make conservative, carefully considered adjustments, as overly aggressive measures can tip the economy into a recession.

High inflation pressures corporate profits, as rising costs for materials and production can outpace companies’ ability to increase prices. This can lead to declining stock prices, particularly in sectors sensitive to input costs like manufacturing and retail. Certain sectors, like energy and consumer staples, tend to perform better during inflationary periods because they usually have more pricing power, allowing them to pass higher costs on to consumers without significantly impacting demand.

You can also see the effect of inflation within the bond market. Inflation erodes the purchasing power of fixed-income returns, making bonds less attractive to investors. As a result, bond prices typically fall during inflationary periods while yields adjust upwards to compensate for the increased inflation risk.

But not every sector of the market suffers when inflation rates rise. Commodities like gold and oil often benefit during inflationary periods as they serve as traditional hedges against rising prices. Gold, in particular, is seen as a store of value when the purchasing power of fiat currencies declines. Similarly, real estate also tends to perform well during periods of high inflation and is traditionally used as a defensive hedge like gold.