What is Inflation? How It Affect Your Purchasing Power

Talia Lee-
June 13, 2024

No one desires a reduction in their income, yet in the face of inflation, many Americans find themselves compelled to accept just that.

As Americans emerged from pandemic-related lockdowns with pent-up spending and a willingness to consume, inflation emerged as a significant threat to both household finances and the broader economy, a situation not seen since the 1980s. This economic phenomenon carries a notorious reputation among policymakers, investors, and consumers alike. Since February 2020, when the recession triggered by the outbreak began, prices have surged by 20.8 percent, according to the National Bureau of Economic Research. This means that what originally cost $1,000 now requires $1,208 to purchase the same goods and services.

The impact of high inflation extends beyond mere affordability, complicating efforts to save for emergencies or plan for retirement. Moreover, Federal Reserve officials have been swiftly increasing interest rates to rein in the spike in U.S. living costs, even at the risk of triggering a recession or slowing job market growth.

However, it’s important to note that not all inflation is detrimental. Fluctuations in prices across the economy are influenced by various factors related to supply and demand. Here’s a breakdown of what inflation signifies and what it doesn’t, and why it holds such significance for your financial situation.

Inflation occurs when prices of goods and services that consumers regularly purchase—ranging from services like haircuts and medical care to goods such as appliances and furniture—rise over an extended period. It’s not an immediate event triggered by a single product’s price increase.

For instance, if you buy a dozen eggs for $2 at the grocery store one week and then find them priced at $4 the next week, this isolated price hike doesn’t qualify as inflation. Prices in the economy are in constant flux, particularly for food and energy costs. Instead, inflation refers to a broader trend.

“As consumers, we might notice price increases in items like gasoline or milk, but it’s not considered inflation unless we observe prices rising across a wide range of products and services,” explains Jordan van Rijn, who teaches agricultural and applied economics at the University of Wisconsin’s Center for Financial Security.

Each year, a gradual increase in prices across the U.S. economy is expected. A modest level of inflation is typically viewed as a positive indicator for a healthy economy, ensuring that businesses can continue to hire and allowing consumers’ incomes to grow. Federal Reserve officials aim for an annual inflation rate around 2 percent, which has become a widely accepted benchmark for stable inflation.

“This level of inflation allows the economy to adjust prices gradually,” explains John Cunnison, CFA, Vice President and Chief Investment Officer at Baker Boyer Bank. “Companies can incrementally raise wages, achieving a ‘goldilocks’ scenario of inflation—not too low and not too high.”

Conversely, inflation becomes problematic when prices surge much faster than 2 percent annually, outpacing the growth of Americans’ incomes. This situation forces consumers to make difficult choices about their spending priorities and may lead to increased reliance on credit card debt. Unforeseen price hikes also pose challenges for businesses, making it harder for them to plan ahead and set prices effectively for their goods and services.

There are primarily two main methods to gauge inflation:

  1. The consumer price index (CPI) by the Bureau of Labor Statistics (BLS).
  2. The personal consumption expenditures (PCE) index by the Department of Commerce.

CPI is especially relevant for consumers as it tracks changes in prices for nearly 400 specific items, ranging from peanut butter to stationery. It plays a significant role in determining Social Security Administration (SSA) cost-of-living adjustments (COLA) and even informs adjustments to federal tax brackets by the Internal Revenue Service (IRS), impacting millions of Americans directly.

On the other hand, PCE is crucial for the Federal Reserve (Fed) as it guides their decisions on key interest rates, which in turn influence consumer borrowing costs. Officially, policymakers target PCE instead of CPI.

This preference is significant because CPI and PCE present different perspectives on inflation. While both indices capture similar trends, CPI typically shows a faster rate of increase than PCE. This disparity arises because they use different methodologies and weightings to calculate inflation. For instance, CPI places significant emphasis on housing costs, which are currently driving inflation higher with a 3.3 percent increase from a year ago, compared to PCE’s overall inflation rate of 2.7 percent.

To gain a comprehensive view of inflation trends, economists commonly monitor year-over-year fluctuations in the overall price index, which smooth out temporary spikes or drops and seasonal influences. They also utilize three- and six-month moving averages to highlight recent patterns. Excluding volatile categories like food and energy provides insights into core inflation, revealing underlying price trends.

Households, however, perceive the U.S. economy differently.

To begin with, not all households purchase the same goods. The inflation rate that consumers experience depends on their spending habits, leading to individual inflation rates that may be lower or higher than the overall index. For instance, drivers might feel a stronger inflationary impact due to rising costs of insurance and repairs compared to those who use public transportation. Families may also perceive inflation as more severe if they are funding college education or healthcare, sectors that have seen prices rise faster than the overall inflation rate.

Another important distinction: Inflation rates differ from price levels. Even if inflation slows down, households often recall previous costs, such as filling up their gas tank or buying groceries, which can shape their economic perceptions.

Economists categorize the causes of inflation primarily into two groups: demand-pull and cost-push inflation. These terms may sound technical, but they mirror experiences familiar to many Americans, particularly in the aftermath of the coronavirus pandemic.

However, there are also other factors that do not neatly fit into these categories. Moreover, as observed post-pandemic, all these inflationary pressures can intersect, compounding the challenge of addressing price increases.

Cost-push inflation arises when prices escalate due to increased production costs, such as higher wages or material prices. Companies respond by raising prices to offset these heightened expenses, thereby contributing to a cycle of rising living costs.

Conversely, demand-pull inflation occurs when there is persistent consumer demand for a product or service. This demand can stem from factors such as low unemployment rates, high consumer confidence, or low interest rates. However, companies may struggle to meet this strong demand, causing shortages of products and subsequently driving up prices.

The anticipation of higher prices alone can have negative consequences. When consumers anticipate price increases, they may engage in panic buying or demand higher wages. These actions together contribute to the very inflationary pressures that consumers fear.

“If people anticipate high inflation, prices will continue to climb,” explains van Rijn. “For executives setting wages in their companies, these decisions hinge partly on expectations for next year’s price increases. As wages rise, businesses respond by increasing their prices.”

High inflation became a significant issue during the 1970s and 1980s, peaking at 12.2 percent in 1974 and 14.6 percent in 1980. During this period, the central bank failed to sufficiently reduce demand through higher interest rates despite substantial government spending and two oil price shocks.

Swift inflation can indeed be painful, but there are other types of price pressures that can pose even greater risks to the economy and the purchasing power of Americans.

Stagflation occurs when unemployment rises, demand slows, and economic growth declines, yet inflation remains stubbornly high. Normally, slowing growth and rising unemployment have an inverse relationship with inflation: fewer paychecks lead to reduced spending, which in turn restricts businesses from expanding or investing.

Specific conditions must align for stagflation to occur, typically stemming from persistent supply shortages that constrain the productive capacity of the U.S. economy. Stagflation can manifest in varying degrees of severity. In its worst form, it can coincide with a recession while inflation spikes. In milder but still challenging scenarios, economic growth may stagnate.

Managing stagflation is particularly challenging because the conventional method of controlling inflation—raising interest rates—is not immediately effective.

Hyperinflation occurs when prices skyrocket at an extreme rate, often reaching around 50 percent or more per month. This phenomenon is exemplified by historical events such as Germany in the 1920s or more recent examples like Venezuela and Zimbabwe. Hyperinflation is typically triggered by a rare combination of policy errors, including excessive government spending and debt accumulation, coupled with a rapid expansion of the country’s money supply.

Secure the best spot for your cash: Not all inflation is detrimental, but those who stash their money at home or in traditional banks risk losing value to inflation. Historically, investing in financial markets has proven the most effective way to preserve and grow purchasing power, whether you’re planning for retirement or the short term. Currently, high-yield savings accounts offer annual percentage yields (APYs) of 5 percent or more, surpassing inflation.

Maintain a budget: During periods of high inflation, closely monitoring your budget becomes crucial. Stay informed about your expenses and assess what you can comfortably afford.

Seek the best deals: With prices escalating across the board, combatting inflation becomes challenging. However, leveraging technology to identify the most economical products and compare alternatives can lead to substantial long-term savings. Additionally, explore coupon options or retailers offering price matching.

Build an emergency fund: While some may hesitate to keep excess cash on hand during inflationary periods, establishing a robust emergency fund becomes essential. High inflation often coincides with increased interest rates and heightened risks of economic downturns, potentially raising credit card borrowing costs.

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