What Is Inflation, Anyway?

Angela Colley — Building Blocks

Simply put, inflation is the increasing price of goods and services over time. When prices go up, the value of a dollar goes down and your cost of living increases. For Americans who came of age in the last decade or so, talk of inflation has barely risen above a whisper. But in the past few months, it’s become a buzzword again as the economy seems to have finally shaken its Great Recession hangover. The truth is, inflation has always been all up in your finances—and that isn’t necessarily a bad thing.

Let’s look at how it happens in the first place. Largely, inflation is the effect of one of three scenarios. The most common is demand-pull inflation—that’s where the economy is humming along so demand for goods and services increases and eventually outpaces the available supply, causing prices to rise. The second is cost-push inflation—that’s where supply is restricted, but demand hasn’t decreased. Say, for example, a hurricane in the Gulf of Mexico temporarily limited oil production, causing gasoline prices to surge. The third is built-in inflation, which is largely about perception. Inflation happened in the past so people expect inflation to occur again in the near future, creating a sort of self-fulfilling prophecy. For example, workers fear oncoming inflation, so they demand higher salaries to cover their cost of living. Companies fork over the increase and pass down the cost to the consumer by raising prices.

Each month, the inflation rate is measured by the Consumer Price Index, a massive report of consumer goods and services compiled by the Bureau of Labor Statistics. But wait, there’s more. The Federal Reserve also has a hand in regulating inflation. The Fed sets the federal funds rate, which controls the money supply, and that, in turn, has a significant effect on interest rates and how the economy flows. If inflation is seen looming on the horizon, the Fed can up the federal funds rate, which would hike interest rates and, theoretically, cool off demand. For many years after the Great Recession, the Fed’s policy was the opposite, and it kept the federal funds rate low in order to spur a sluggish economy. But it’s a tricky balancing act, because any time interest rates rise, the fear is that the economy might contract too much, but go the other way, and the economy could overheat with rapid inflation. Since 2011, the Federal Reserve has opted for a 2 percent annual inflation rate increase as a benchmark to keep things steady. Due to healthier economic demand, that’s meant interest rates have gone up a quarter of a percentage point to between 1.5 and 1.75 percent in the past year.

Inflation largely gets a bad rap because it seems like prices just keep rising and there’s nothing you can do about it. But if you examine inflation’s impact on your finances, you can take the sting out of it, and maybe even make it work for you.

Inflation and your dollars

If you account for inflation when you’re making your everyday money moves—say by deciding where to stash your emergency fund or if you should take out that personal loan—you can offset inflation’s impact and you may even end up making money on the deal. But if you don’t account for inflation, even a small percentage hike can hurt you.

Your big investments

Beyond your everyday dollars, inflation also plays a big part in your biggest purchases, like your home, for example. When you’re considering buying a house, paying attention to inflation can help you time your buy to get a lower interest rate on your mortgage, which can mean the difference of thousands of dollars over time. And if you can’t score a super-low interest rate, considering inflation can at least give you a nice silver lining when you do lock in your mortgage payment.

Your retirement

Inflation will also follow you through to your golden years. Deciding how much you’ll need to save to live comfortably in retirement depends on factoring in how much the cost of goods and services will rise in the meantime.

*All infographics designed by Eli Miller