There are a number of factors that can cause inflation, including an increase in the cost of raw materials, an increase in the currency supply, and more. When the cost of goods and services rise over time, and consumers have to spend more to buy basic items, that’s considered inflation.
Inflation is an economic reality, but the government tries to regulate inflation so that it remains at a low but steady pace. The target is 2.0%, but historically it’s closer to 3.3%. A period of higher inflation began in early 2021, thanks in part to supply chain bottlenecks resulting from the pandemic.
Inflation isn’t necessarily a bad thing — it can also result from an economic upturn. But when the prices of goods and services rise in relation to the dollar, or the currency in use, the result is that each unit of currency will buy less of just about everything than it previously did.
Here’s a closer look at how to track inflation, and seven factors that cause prices to increase.
How to Track Inflation
The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is produced by the U.S. Bureau of Labor Statistics (BLS) each month. The CPI tracks the average of prices of a set of goods and services. While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living.
What Is Core Inflation?
Core inflation also measures the rising cost of goods and services, but it excludes food and energy costs. The reason being that both food and energy prices are partly driven by the price of commodities — which tend to be volatile, owing to speculation in the commodities markets. So the short-term price changes in food and energy make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.
The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.
Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.
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Types of Economic Inflation
There are a range of different types of inflation, although they are fundamentally interrelated.
Cost-Push Inflation
Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities. For example, owing to high demand for certain types of minerals used in technology equipment, the prices for those goods are likely to rise.
Demand-Pull Inflation
Rising demand for goods and services can trigger inflation when there’s an imbalance in supply vs. demand. This is known as demand-pull inflation. For example, if there’s a high demand for pork (or if there’s a slump on the supply side owing to pork shortages), that could drive up the price of bacon, ham, and other pork products.
Built-In Inflation
Built-in inflation is the result of an upward spiral in wages, as workers seek raises to keep up with the cost of living. This in turn can lead businesses to raise their prices, adding to the higher prices.
As you can see, these three types of inflation are connected through the loop of supply and demand.
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What Causes Inflation?
While inflation has become a persistent factor in most of the world’s economies, it can result from a range of different causes. Understanding the different causes can help investors manage inflation risk — i.e. the possibility that the money you invest won’t earn enough to keep up with inflation.
1. The Economy Is Going Strong
When the economy is growing, more people have jobs, wages increase in order to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on luxury items.
In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices across the board: aka inflation.
This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy. As noted above, this kind of inflation is a type of “demand-pull inflation,” because it is driven by consumer demand.
In fact, deflation — when the prices of goods fall for a period of time — can also be considered unhealthy because it can mean demand among consumers is weak.
2. There Is More Currency Available
Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.
One reason that inflation has been a constant in the U.S. since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.
In response to the Covid-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021 — and were not surprised when inflation began to climb through 2022.
3. Basic Materials Increase in Price
In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increases in the prices of manufacturing and shipping for nearly every single consumer good.
Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.
Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.
Recommended: Guide to Investing in Oil
4. The Housing Market Takes Off
The housing market is a major part of the U.S. economy, and it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.
At the same time, a strong housing market means that homeowners, contractors, and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber, and oil, which can lead to more inflation.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
5. The Government Implements Expansionary Fiscal Policies
The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.
Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.
Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.
6. New Regulations Increase Costs
While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.
Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.
7. The Exchange Rate Changes
The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.
The Takeaway
Inflation in the U.S. has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.
Inflation was fairly gradual in the decades since then, but after stimulus packages during the Covid-19 pandemic and a reopening of the economy boosted prices and growth, inflation took off. It reached a peak of about 9.02% in June of 2022, and has eased down closer to the historical average of about 3.28% throughout 2023.
The forces that can stir or mitigate inflation are important for investors to understand. Managing your investment strategy in light of the inevitable impact of inflation can help offset inflation risk — the risk that your money won’t retain its purchasing power in the future.
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FAQ
How does raising interest rates help inflation?
Higher interest rates may help slow spending, because the cost of borrowing increases as rates rise. People may also be inclined to take advantage of higher rates by saving more, which can also slow demand and cool the economy.
How quickly does inflation decrease to normal levels?
Cycles of inflation historically have lasted many years, or a couple of months. How quickly inflation subsides depends on economic conditions overall, as well as the origins of a particular bout of inflation. If employment numbers change, if interest rates rise or fall, if demand overshoots supply — these are among the factors that can influence inflation.
Who benefits from inflation?
There are a couple of scenarios where inflation can be beneficial. For example, those with bigger debts can benefit from inflation because the money they’re using to pay off their car or home loan, say, is now less valuable than the money they borrowed. Those working in jobs made more secure by rising demand can also benefit. In some cases, holding foreign currency may be more beneficial in relation to the inflationary currency. Inflation is fluid, and it’s important to gauge which factors are at play before deciding what is beneficial or not.
Who is hurt most by inflation?
Lower-income households are disproportionately affected by inflation, because the cost of goods and services is rising faster than wages. Another group hit hard by inflation is retirees and those living on fixed incomes, because their money is buying less over time.
Photo credit: iStock/Delmaine Donson
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