The Reason Why You Should Know About Inflation

To understand inflation you must learn about its causes, how it can be measured, how it affects investors, savers, and borrowers, and how it can be controlled.

Inflation is the increase in the general price level of goods and services. In an economy, prices increase when a particular good or service gets more expensive. The Federal Reserve defines price stability as a long-run inflation rate of around 2% per year, a benchmark that guides monetary policy decisions across the United States.

Prices do not rise uniformly across every group or market. Over time, lower-income households have felt the pressure most acutely, largely because a larger share of their budgets goes toward essentials like oil, healthcare, and fuel, categories that have historically seen above-average price swings. High inflation typically prompts central banks to raise interest rates in response. One honest caveat worth naming: those rate increases can slow an economy sharply, and households with variable-rate debt often feel that squeeze before inflation itself retreats. The cure is not painless.

How is inflation measured?

Measuring inflation is not straightforward. Multiple methods exist, and depending on the country and institution, different measurements carry different meanings. In the United States, the Personal Consumption Expenditures Price Index (PCE) serves as the Federal Reserve’s primary inflation gauge. The Producer Price Index (PPI), published by the Bureau of Labor Statistics, tracks price changes from the seller’s perspective. Germany uses the Consumer Price Index (CPI), while the United Kingdom uses the Retail Prices Index (RPI). How these indices work depends on how index operators collect prices for goods and services. Some rely on a “market basket of goods,” gathered from stores and tracked over time. Others are based on prices of individual goods and services. A third method is the implicit price deflator (IPD), which the Bureau of Economic Analysis uses when calculating real GDP growth.

What causes inflation?

Various factors can cause inflation, but the core issue usually comes down to the amount of money in circulation. When more money is in circulation, prices go up. Economists refer to this as demand-pull inflation, where too many dollars chase too few goods. A second cause, cost-push inflation, occurs when production costs, such as oil, wages, or raw materials, rise sharply, forcing businesses to pass those costs on to consumers. The International Monetary Fund (IMF) identifies both of these as primary inflation drivers in its economic research. Inflation levels are generally expressed as a percentage change from the prior period. If the price level rises 10% from last year, the inflation rate is 10%. That said, inflation does not always mean every price rises, in specific segments like commercial construction, greater building efficiency has sometimes held prices down even when broader inflation was climbing.

The supply of money growing faster than the supply of goods and services is what pushes prices up. Central banks like the Federal Reserve have tools to bring inflation back toward target, but those tools take time to work and must be applied with careful judgment to avoid tipping the economy into recession. This tradeoff between fighting inflation and risking slower growth is one reason the Federal Open Market Committee (FOMC) moves gradually rather than making sweeping changes at once.

What is an example of inflation?
The industrial revolution, starting in England in the late 18th century, led to a dramatic increase in the volume of goods and services produced and consumed at each point on a consumption path. To support the production of wide-ranging products, clothing, food, housing, capital markets in some countries developed financial tools that let investors purchase production services from many small suppliers. A more modern example is the post-2020 inflationary period, during which the Federal Reserve raised the federal funds rate aggressively, from near 0% to over 5% between 2022 and 2023, in an effort to bring inflation back toward its 2% target.

How can inflation be controlled?
Several tools are available to control inflation. Governments can work to stabilize the money supply and interest rates, sometimes combined with wage and price controls. A central bank buying government bonds is another lever: when bonds are purchased and held as assets, interest rates tend to stay lower than if those bonds were sold into the market. The difference in interest payments between a held bond and a sold one can offset some of the extra cost that inflation creates over time. Central banks must be careful about timing, since the market impact of any action can ripple widely. The Federal Open Market Committee (FOMC) meets eight times per year specifically to evaluate inflation data and set the federal funds rate accordingly.

The relationship between inflation and profit margins signals how much room exists for wage increases. If wages rise, product prices tend to follow, which can suppress sales. Businesses then cut costs by reducing staff, a cycle that leads to unemployment and less consumer spending. Financial platforms like SoFi note that this wage-price spiral is one of the most difficult inflationary dynamics for central banks to unwind once it takes hold.

The interest rate is the price of money. A high rate slows spending and borrowing; a very low rate can stoke inflation by making credit cheap. Getting that balance right is the central challenge of monetary policy. When the federal funds rate rises, so do the annual percentage rates (APRs) on consumer products, credit cards, auto loans, and mortgages all become more expensive to carry. As of mid-2022, the average credit card APR in the United States had already begun climbing sharply as a direct result of the Fed’s rate-hiking cycle.

Many consumers do not realize that inflation works against savers in a concrete way. If your savings account yields 1% but inflation is running at 4%, you are effectively losing 3% of your purchasing power every single year. Building an inflation-aware financial plan is essential for long-term financial health, though it is worth being clear that even inflation-adjusted instruments like TIPS are not perfect hedges; their real yields can still be negative when demand for safe assets is high and nominal yields have not caught up to actual price pressures.

How does inflation affect investment returns?
When inflation is high, the nominal return on an investment is effectively lower. Purchasing power erodes, which means a higher nominal return is required just to break even in real terms. An investor can compensate somewhat by selling at a higher price to realize a capital gain, but unless other forces are increasing the value of the asset, such as increased demand or decreased supply of similar investments, the asset may not appreciate enough to fully offset inflation. Holding an investment longer is another option, though if inflation exceeds the return, it simply takes more time to recover equivalent purchasing power. Treasury Inflation-Protected Securities (TIPS), offered through TreasuryDirect, are one instrument specifically designed to address this erosion, as their principal adjusts automatically with CPI changes.

For investors trying to model real versus nominal returns, tools from institutions like Chase can help illustrate how a debt-to-income (DTI) ratio can shift during inflationary periods when income does not keep pace with rising costs. If inflation rises, the actual real cost of investments increases, and if inflation runs higher than the nominal return, the result is an actual loss in purchasing power, not just a slower gain.

Savers face a direct headwind from rising prices. Banks see profit margins compressed during high-inflation periods, which limits how much interest they can reliably pass on to depositors. High-yield savings schemes become more attractive in theory, but only if the rate offered genuinely outpaces inflation, something that is rarely guaranteed. The FDIC advises consumers to compare high-yield savings account rates against the current CPI when evaluating whether their savings are keeping pace with inflation. A strong FICO Score can help savers access higher-yield financial products that may partially offset inflation’s impact on their purchasing power.

Borrowers with fixed-rate loans tend to benefit from inflation because they repay the loan using money worth less than what they borrowed. The CPI does not take into account the time value of money. The Consumer Financial Protection Bureau (CFPB) explains that fixed-rate mortgage borrowers, in particular, can see a real benefit during inflationary periods, the nominal dollar value of their monthly payment stays the same while the real value of that payment declines over time as money loses purchasing power.

Four practical lessons emerge from studying inflation. First, inflation is driven by excess money in circulation relative to goods and services. Second, controlling it requires managing the money supply and interest rates together. Third, inflation can temporarily expand profit margins for businesses, but only until higher wages and input costs catch up. Fourth, investors and savers lose ground in real terms when inflation outpaces the returns on their holdings, while fixed-rate borrowers are among the few who can benefit from a high-inflation environment.

Frequently Asked Questions

What is inflation in simple terms?

Inflation is the gradual increase in the price level of goods and services over time, which reduces the purchasing power of money. A dollar today buys less than a dollar did ten years ago because of inflation. The Federal Reserve targets an annual inflation rate of 2% as a healthy benchmark for the U.S. economy.

What are the main causes of inflation?

The main causes are demand-pull inflation (too much consumer demand chasing limited goods), cost-push inflation (rising production costs passed on to consumers), and built-in inflation (wage-price spirals). Excess money supply is the root driver in most cases, which is why central banks like the Federal Reserve closely monitor money circulation and set interest rate policy accordingly.

How is inflation measured in the United States?

In the United States, inflation is primarily measured using the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) Price Index. The CPI is published monthly by the Bureau of Labor Statistics and is used to calculate cost-of-living adjustments. The PCE is published by the Bureau of Economic Analysis and is the Federal Reserve’s preferred inflation measure. The Producer Price Index (PPI) also tracks inflation from the seller’s perspective.

What is a good inflation rate?

Most economists and the Federal Reserve consider 2% annual inflation to be a healthy target rate. At this level, inflation is low enough that it does not significantly erode purchasing power, but high enough to allow businesses and workers some pricing flexibility. Inflation significantly above or below this target signals economic imbalance.

How does inflation affect my savings account?

Inflation directly reduces the real value of money sitting in a savings account. If your savings account earns 1% interest but inflation is running at 4%, your real return is negative 3%, meaning your money is actually losing purchasing power each year. The FDIC recommends comparing your savings yield against the current CPI to understand whether your savings are keeping pace with rising prices.

How does inflation affect borrowers?

Borrowers generally benefit from inflation when they hold fixed-rate loans. Because they repay the debt with dollars that are worth less than when they borrowed, the real cost of their debt declines over time. A homeowner with a fixed-rate 30-year mortgage at a set monthly payment effectively pays less in real terms as inflation rises, one of the few groups that can benefit from a high-inflation environment, as noted by the CFPB.

How does the Federal Reserve control inflation?

The Federal Reserve controls inflation primarily by adjusting the federal funds rate through the Federal Open Market Committee (FOMC). Raising the federal funds rate makes borrowing more expensive, which slows consumer spending and business investment, reducing demand-pull inflation. The Fed can also use open market operations, buying or selling government bonds, to influence the money supply directly. These tools take 12 to 18 months on average to fully affect inflation, according to the Federal Reserve’s own research.

What is the difference between CPI and PCE inflation measures?

The CPI measures the price change of a fixed basket of goods and services purchased by urban consumers, while the PCE adjusts its basket dynamically based on actual consumer spending patterns. As a result, the PCE tends to run about 0.3 to 0.5 percentage points lower than the CPI. The Federal Reserve prefers the PCE because it better captures how consumers substitute cheaper products when prices rise, giving a more accurate picture of real-world spending behavior.

What is hyperinflation and how does it occur?

Hyperinflation is an extreme form of inflation where prices rise uncontrollably, often defined as price increases of more than 50% per month. It typically occurs when a government prints excessive amounts of money to cover fiscal deficits, causing the currency to lose value rapidly. Historical examples include Zimbabwe in the 2000s and Germany during the Weimar Republic in the 1920s. The IMF has identified weak central banking institutions and unsustainable government spending as the primary causes.

How does inflation affect my credit card APR?

Inflation leads the Federal Reserve to raise the federal funds rate, which directly pushes up the prime rate, the baseline that banks use to set variable APRs on credit cards. When the federal funds rate rises, credit card APRs follow almost immediately. Carrying a balance during a high-inflation period becomes significantly more expensive for consumers as a direct result of that rate-hiking cycle.

Who does NOT benefit from inflation?

Retirees and others living on fixed incomes are hit hardest, since their income does not adjust upward while prices do. Savers holding cash or low-yield accounts also lose ground in real terms. Variable-rate borrowers face a double squeeze: prices rise at the same time their interest costs climb because the Fed is raising rates to fight that same inflation. Inflation is not a universal equalizer, it redistributes wealth in ways that tend to favor asset holders and fixed-rate debtors while penalizing those without pricing power.

What is the difference between inflation and deflation?

Deflation is the opposite of inflation, a general decrease in prices over time. While falling prices might sound appealing, sustained deflation is economically damaging. Consumers delay purchases expecting prices to drop further, businesses cut production, and unemployment rises. The Federal Reserve considers moderate inflation preferable to deflation precisely because deflationary spirals are harder to escape than inflationary ones. Japan’s experience through much of the 1990s and 2000s is a widely cited example of how prolonged deflation can stall an economy for years.