What is Inflation? (And How to Protect Yourself)
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Fast Facts
Definition:
Inflation is the rate at which prices for goods and services rise, reducing purchasing power.
Causes:
Driven by demand-pull (high demand), cost-push (higher production costs), and built-in (wage-price spirals) factors.
Measurement:
Measured using the Consumer Price Index (CPI) and Producer Price Index (PPI).
Effects:
Reduces purchasing power, creates uncertainty, and redistributes income, benefiting borrowers and harming savers.
In 1974, as inflation reached 11.04%, President Gerald Ford had an idea: encourage people to save and make disciplined spending. Favoring voluntary actions by people over price restrictions, he suggested that citizens carpool and turn down thermostats to combat inflation as part of his "Whip Inflation Now" movement. Millions of "WIN" buttons were manufactured, and people were encouraged to wear them to evoke solidarity. The plan failed miserably and was later described as a major government PR blunder.
Today, following the pandemic, inflation continues to accelerate rapidly. Thankfully, politicians didn't try to intervene this time around. Instead, the Federal Reserve, which is tasked with setting the monetary policy, responded by increasing interest rates to tamp down inflation. Is it enough? Gas prices are soaring, goods in the grocery store are becoming more expensive, and Americans are paying more for practically everything they were spending this time last year. So, what is inflation, and what can you do?
In this article
What is inflation?
Inflation is a complex topic but in its most basic form, inflation is the decline of your purchasing power. Here's another way to put it: Items that could have been bought for $10 a few years ago can no longer be bought for the same amount of money today because of price increases (aka inflation). For example, the USDA reports a 5% increase in food costs in 2023 over 2022.
When money loses value, it leads to higher prices, which affords fewer goods and services. As a result, the cost of living increases, which puts the brakes on economic growth. For a healthy economy to operate, a stable and low rate of inflation is a must. However, when that balance is lost, inflation can spell disaster. If price changes become unpredictable, people cannot confidently plan how much they can save and how much should be spent.
How bad is this? When Venezuela and Zimbabwe abandon prudent fiscal policy, hyperinflation set in and reached a whopping 2,355.2% and 557.2%, respectively, in 2020. This rendered the countries' currency essentially worthless, according to Statista. When inflation reaches 50% or more and sustains that level for a month, it is described as hyperinflation.
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Types of inflation
Stagflation
Financial insiders highlight America is entering a period of stagflation. The last time the U.S. experienced stagflation was 1973–1975 and then the 1980 recession when inflation topped 10% and the unemployment rate was rapidly rising. Stagflation is a result of high inflation, stagnant economic growth, and rising unemployment. In normal economic conditions, higher unemployment is accompanied by lower spending, which brings down demand and thus prices. High prices characterize stagflation even amid low consumer spending.
Hyperinflation
Rapidly rising inflation and currency devaluation result in hyperinflation, defined as prices rising by at least 50% every month. Hyperinflation can result following a war, civil unrest, or another major event. Germany experienced hyperinflation between World War I and World War II. Hyperinflation forces countries to make tough decisions to bring inflation down to an acceptable level, going as far as giving up their national currency, as Zimbabwe eventually did.
What causes inflation?
The typical inflation can be lumped into the following categories, which combine to become the inflation that affects us.
Demand-pull inflation
Demand-pull inflation occurs when demand for goods or services goes up, but supply remains the same, which results in price increases. In other words, when an item's supply can't keep up with demand, it drives the price higher. This phenomenon is called demand-pull inflation.
To help you better understand, let's look at the example of baby formula shortage. If the product's demand is 5%, but the production is 3%, demand is outstripping supply. To meet the higher demand, manufacturers will hire more workers, creating jobs and lowering the unemployment rate in the grand scheme of things. Because of the increased demand for workers, wages will go up, which would increase spending.
This played out during 2021, when some significant economies began to reopen following COVID restrictions. Armed with stimulus money, people began to spend more and travel more, which led to a bottleneck with high demand. Amid this confluence of occurrences, prices rose markedly.
Cost-push inflation
Supply-side factors drive cost-push inflation. Higher prices characterize it amid increasing production costs such as rising oil prices or shortages of raw materials, while demand remains unchanged. Here's another way to look at it: A product's demand is unchanged, but its supply takes a hit due to higher production costs, which are ultimately passed on to the end-user in the form of price increases. This is cost-push inflation.
Although this type of inflation only lasts for a short period, it can contract economic activity and result in lower living standards. Just like demand-pull inflation, cost-push inflation is currently in motion following Russia's invasion of Ukraine leading to higher energy prices, the pandemic-induced supply chain disruptions continue, and food prices are also jacking up.
Built-in inflation
This type of inflation isn't necessarily connected to supply and demand but rather to expectations of inflation in the future, i.e., factors that don't need a pandemic to spur them.
When inflation kicks in, there's always an expectation that inflation will rise in the future. Against this backdrop, workers demand that their wages be raised to meet the rising cost of living. This pushes the price of goods higher as the additional cost is passed onto the consumer. This cycle of wage increase followed by higher prices is built-in inflation.
Built-in inflation feeds into demand-pull inflation as workers now have more income and cost-push inflation because the employer's cost has risen. In addition, the company may preemptively raise prices because of expected inflation.
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How is inflation measured?
Prices for individual goods and services constantly fluctuate. Sometimes they rise, while other times they fall. Inflation is characterized by an overall increase in the average price level of goods and services, i.e., not limited to individual items. But how do we know if a price hike can be characterized as an indicator of inflation?
Government agencies collect the prices of many goods and services, and they create a so-called "basket" of these goods and services to reflect the items consumed by households. This basket doesn't contain every good or service but rather is meant to represent the type of items households generally tend to consume. But spending habits differ, so data is limited to items likely to be consumed by every household, e.g., food, gas, clothing, insurance, and utilities.
This basket of goods and services is then used to create a price index. The three most common indicators of rising prices in the U.S. are the Consumer Price Index, the Personal Consumption Expenditures Price Index, and the Producer Price Index. But a price index such as this doesn't fully capture the broader picture. Instead, they give an idea of the price level compared to a base year. To arrive at the inflation percentage, government agencies compare the index's value over a period to its value at another time. Put another way, inflation is the basket's price in a month compared with its price in the same month a year earlier.
How central banks act
Central banks are tasked with setting monetary policy and keeping inflation stable. To cool an overheated economy, it can pull a few levers to steady the ship and bring about price stability. In the U.S., the Fed has determined that an inflation rate of 2% is optimal; the most recent reading came in at 8.3%.
In a low interest rate environment, borrowing money is cheap, and there isn't any incentive to save because money parked in savings accounts isn't multiplying fast enough. As a result, people spend more, which pushes inflation higher. Central banks typically increase interest rates to kill a surge in inflation and rein in demand. This achieves two things. First, it makes borrowing money expensive. So, if you go to the bank for a loan, you'll be charged a higher interest rate, and any loans and mortgages you currently have will also end up costing you more than before the interest rate hike. Secondly, higher interest rates encourage people to save and be mindful of their spending. As people spend less on goods and services, prices gradually rise, which ends high inflation and brings it down to an acceptable level.
In addition to interest rates, central banks can deploy asset purchase programs and use foreign exchange interventions to bring down inflation
Pros and cons of inflation
Pros
- Economic growth. As inflation increases, consumers do not have an incentive to save money, so they start spending and investing more. This boost in spending and investments spurs economic growth, at least in the short term. Interestingly, inflation and employment have an inverse relationship. Because the economy is doing so well, employers hire more workers, which boosts growth and helps to bring down unemployment.
- Higher asset prices. Inflation discourages spending and is faced with low interest rates. People spend more rapidly or park their cash in the stock market, real estate, and other illiquid assets, thereby driving up the price. Central banks' policies revolve around minimizing price inflation, but asset inflation hasn't been the subject of much concern.
Cons
- Weakens purchasing power. This is what inflation essentially is — your money loses value. As prices rise faster, your dollars don't go as far as they used to. Indeed, Finbold said that the U.S. dollar had lost 85% of its value over the past 50 years. When prices go up, consumers have to pay more, and resultantly, they can only afford less. As consumers face an eroding purchasing power, they may look to invest in inflation-proof investments (more on that later) out of fear that their money will become worthless.
- More inflation. Persistently high prices have a psychological effect on people: they become convinced that it may be a while before rising inflation is brought to a heel. As a result, people start spending money on items just so they don't hold onto cash losing value, which drives prices higher and thus inflation — essentially becoming a self-fulfilling prophecy.
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How to protect yourself from inflation
Invest in stocks
The stock market has been in free fall for the past few months, but investing in the stock market may be a good way to hedge against inflation. Individual stock prices fluctuate all the time, and there's a possibility a company may go out of business. But over the long run, broader stock market indexes may prove an inflation-proof investment. For example, the annualized growth rate of the S&P 500 is about 7% after adjusting for inflation. As those fearful of losing money in the stock market sell to cut their losses, smart investors are buying more stock while prices are low, knowing the bounce back will help them earn faster rewards.
Invest in bonds
Bonds are an ideal investment for the risk-averse investor, but they offer lower returns compared to stocks. Anyone looking to build a nest egg can invest in bonds because they provide consistent returns and beat inflation. Treasury Inflation-Protected Securities are specifically designed to protect from inflation. The payout is fixed, and the principal value of these bonds corresponds with the inflation rate.
Related: Stocks vs. Bonds
Invest in real estate
As noted, when inflation rises, it also helps to drive up the price of properties. This can allow landlords to charge higher rent, increasing their income and putting it on pace with the rising inflation. Those with real estate that can be rented on Airbnb or longer-term property rentals can benefit from this increase. Alternatively, you can invest in real estate investment trusts and in mutual funds that invest in REITs.
Invest in cryptocurrency
Whether crypto will shield you from inflation over the long term is anybody's guess. But bitcoin, the most famous cryptocurrency, has a limited supply (it is currently 91% of the way through its available coins), so it should, at least on paper, provide a hedge against inflation. But cryptocurrencies are inherently volatile, and many tokens recently witnessed a rout.
Inflation vs. deflation
If inflation is a sustained increase in the price of goods and services, then deflation is the exact opposite. When prices decline and continue that momentum, it's called deflation. Nice, right? No, economists believe that deflation may spell more trouble over the long run than inflation, and the reason has to do with consumers' psychology. If prices are falling, consumers may delay their purchasing decision in hopes of a further decrease in prices. Deflation can bring economic growth to a halt if left unchecked.
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FAQs
What causes inflation?
Inflation can be caused by demand-pull factors (higher demand than supply), cost-push factors (increased production costs), and built-in factors (wage-price spirals).
How is inflation measured?
Inflation is measured using indices like the Consumer Price Index (CPI) and the Producer Price Index (PPI), which track price changes for consumer goods and producer outputs, respectively.
What are the effects of inflation?
Inflation reduces purchasing power, creates economic uncertainty, and redistributes income, often benefiting borrowers while harming savers.
How can inflation be controlled?
Inflation is controlled through monetary policy (interest rates and money supply), fiscal policy (government spending and taxes), and supply-side policies (increasing productivity).
The bottom line
Prolonged periods of price increases across the board are called inflation. It erodes your purchasing power and can psychologically affect people, potentially leading to more inflation. On the flip side, inflation also powers economic growth and leads to higher asset prices. If you're looking for a hedge against inflation, Treasury Inflation-Protected Securities, or TIPS, are your safest bet. Periods of prolonged inflation can also be used to revisit your portfolio and make any necessary adjustments. In any case, don't let the headlines bother you too much. If you're in it for the long run, you'll do just fine.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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