What Is Inflation, and What Causes It?

Justin Makso, Senior Vice President, Investment Specialist, First Republic Investment Management
August 22, 2022

  • Inflation can lead to rising prices and increased cost of living expenses.
  • Current inflation may be due to the impact of the pandemic on the American economy.
  • Inflation may call for hedging strategies within your investment portfolio.

Many of the common staples we buy every week have gotten more expensive. Gas prices, the cost of groceries, and utilities, like electricity, have noticeably risen. News headlines often focus on the effects of inflation, but don’t always answer one core question: what is inflation?  

Inflation often means higher prices for goods and services, be it due to high demand, scarcity or supply chain and logistics issues. Or, in some cases, it can be a mix of these and other factors. Knowing what causes inflation, what an inflation rate really means and how to handle rising prices can help you track changes in your finances and investments.

Inflation definition

Inflation is a general increase in prices and falls in the purchasing value of money. Or an even simpler way of defining inflation is "too many dollars chasing too few goods." Most economists use a basket of goods — a set of general products and its prices — to measure cost fluctuations. This basket of goods then can be used to calculate the Consumer Price Index (CPI), which measures inflation rates. 

The CPI tracks when prices rise and fall. Knowing how the price of goods changes can help you understand the purchasing power of consumers. You can also better understand a location’s standard of living based on the difference between income and expenses. The higher the inflation rate, the more difficulty one will have in maintaining an adequate standard of living. 

Deflation vs. Inflation
Deflation is the lowering of prices of goods and services within an economy. Inflation is the increase in prices of goods and services within an economy. Too much of either can affect economic health.

What causes inflation?

Inflation has several causes, including: supply shortages and increased demand, an increase in the cost of a good or service for which there is no replacement available or it could be due to changes in wages and subsequent price increases. These three common causes are called demand-pull inflation, cost-push inflation and built-in inflation.

Demand-pull inflation

Demand-pull inflation occurs due to supply shortages. If consumers or businesses demand more of something than what’s available, the price of that item rises to meet that demand. For example, if less lumber is available because of high market demand, buyers can expect to pay more for what’s in stock. You may also end up paying more for renovations or construction as well, given a high demand for low stock. 

Cost-push inflation

Cost-push inflation occurs when the price of an essential good or service increases when a suitable alternative is unavailable. For example, if oil prices increase, you are likely to pay more per gallon of gasoline since there is no viable alternative source for oil. 

Cost-push inflation may also occur if the money supply in circulation is greater than the demand for it. An economy with too much cash in circulation may find that the cash looses value which diminishes a consumer's purchasing power. 

Built-in inflation

Built-in inflation refers to the passed-on expenses that buyers pay as a result of increased wages. When employees receive higher pay, their employers often pass these expenses onto their customers. For example, a restaurant that provides employees with a 5% wage increase may increase prices on menu items to ensure they continue making the same profit margin.

How is inflation measured?

Inflation is measured by tracking the percentage change within a basket of goods. The percentage change, be it increases or decreases in price, reflects the inflation rate during that period. 

Consumer price index (CPI)

The CPI measures changes to the cost of goods most consumers purchase. The CPI basket of goods includes common expenses, such as cereal, milk and coffee. The index also uses other common expenses, such as housing, furniture, travel, medical care and recreation. 

Because of its focus on typical consumer expenses, the CPI is often used as a go-to tool for inflation measurement, especially when consumer spending or confidence is concerned. There are also subsets of the CPI, including the CPI-U (for urban consumers) and the CPI-E (for older adults).

To track inflation trends over time, you can use the U.S. Bureau of Labor Statistics' (BLS) inflation calculator

Wholesale price index (WPI)

The WPI tracks the price changes of goods before they reach retail consumers. This includes raw materials and bulk items traded directly between businesses. It is different from the CPI, which includes only consumer goods in its calculations. 

Measuring the WPI can be helpful for economists and business leaders since it lends insight into potential price increases they may face. This can help business leaders, in particular, adjust their pricing and other elements of their business to maintain financial balance.

Producer price index (PPI)

The PPI tracks changes to selling prices over time. The index does this by recording the prices domestic producers received for their output, such as raw goods or supplies. This index tracks the price received by the producer, rather than the price paid by a business or retail consumer. The PPI helps economists track inflation’s effect on producers rather than commercial or retail consumers.

Inflation rate

Price indices play a large factor in how economists calculate the inflation rate. Rates are reflected as the percentage change of a particular price index between two periods (often monthly, quarterly or yearly). Inflation rates use a specific formula for calculations. 

Inflation Rate Formula

The formula for calculating the inflation rate is as follows:

Percent inflation rate = (Final Index Value/Initial Index Value) x 100

A country’s central bank often sets monetary policy that attempts to keep inflation within a certain percentage rate. The Federal Reserve’s target inflation rate for 2022 is 2%, but inflation may be higher or lower by year’s end, regardless of monetary policies and interest rates. Moderate inflation is usually the goal, although central banks only have so much influence on inflation rates.

Effects of inflation

Inflation can affect consumers in several ways, most of which adversely affect consumer purchasing and savings power. Because of inflation and Fed policies, economists suggest that consumers may expect or experience the following outcomes: 

  • The value of your liquid savings declines.
  • Fixed-rate investments generate value more slowly.
  • Purchasing power can decline, thus making you reevaluate your budget.
  • Fixed-rate mortgages may charge less interest than new fixed-rate or variable loans. 
  • The Federal Reserve may raise interest rates to curb spending, which can further inflation.

Inflation hedging

Investors concerned with rising inflation may be interested in inflation hedging techniques or assets for their portfolios. Inflation hedging means investing in assets that have low or negative correlation with industries or investments negatively affected by high inflation. Inflation hedging investments may help curtail inflation-related losses on the stock market.

Real assets tend to be well-suited inflation hedging investments. Gold and other precious metals are common inflation hedges, as is real estate. Some commodities increase in price during inflationary periods, which means they are also a consideration for some investors.

Although it’s important to keep an eye on inflation, it’s also important not to make investing decisions without looking at the bigger picture. If you’re not sure how inflation might affect your finances, it’s best to speak to a financial professional first. That way you can develop an optimized strategy with your money.

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