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Wednesday, July 17, 2024

What causes inflation?

What causes inflation?

Inflation refers to the trend of prices rising in an overall economy. As a result of rising prices, purchasing power diminishes — in short, each dollar you have buys less. 

The opposite of inflation is deflation, which occurs when general prices in an economy drop.

For inflation (or deflation) to occur, price trends can be limited to a single sale, type of good, or even category of good. For example, automobile prices skyrocketing could be attributed to supply and demand issues and not inflation, especially if the prices of other types of goods and services are not rising.

Keep reading to learn more about what causes inflation, how to measure inflation, and other important information about this critical economic force. 

Impact of inflation

Inflation impacts your personal finances because it reduces your buying power. When food, fuel, utilities, and other goods are more expensive, you will want to buy less of them. Sometimes, that leads to households not having enough left over at the end of the month to save money or invest for the future.

Often, inflation makes people more aware of the need to save, so they cut their discretionary and optional spending so they can save. That leads to reduced overall spending in the economy. If inflation is high enough and/or the impact is long enough, this stagnation in the economy can lead to other issues, including low job growth, stock market fluctuations, and a recession.

Worried about inflation eating into the value of your savings? Use our Retirement Planner to model different scenarios based on inflation.

What drives inflation?

Inflation can be caused or driven by a variety of economic factors. In many cases, inflation in the overall economy is a result of multiple factors occurring at or around the same time.

Supply-related inflation

Changes in supply and demand can drive inflation. Again, if the supply and demand issue is in a single niche, this doesn't tend to drive inflation. The issues have to impact enough sectors of major goods and services — such as groceries — to cause overall inflation in the economy. 

Cost-push inflation

Cost-push inflation occurs when the demand for goods and services is the same or growing, but a supply issue of some type means there isn't enough to meet existing demand. The supply shortage might be caused by issues with supply chains, such as transportation strikes. They might also be caused by geopolitical instability, natural disasters, and other large-scale issues.

To address what may be seen as a temporary supply issue, manufacturers, wholesalers, and retailers may increase prices. They do this to slow down purchasing and try to stretch the existing supply over the demand. If demand doesn't go down with that price increase, prices may continue to rise. That can lead to inflation.

Demand-pull inflation

Demand-pull inflation is a slightly different type of supply-related inflation. It occurs when there is not necessarily a shortage or issue impacting existing supply chains. However, because of other forces in the market, including consumer trends or growing populations, demand for goods and services rises to eclipse existing supplies. This drives up prices in a similar way that cost-push inflation does; the initial trigger just comes from the demand side.

Devaluation

Devaluation occurs when a government makes a decision to devalue its currency in comparison to another currency. For example, in early November 2022, the U.S. dollar was worth around 146 Japanese yen. If the United States government decided to devalue the dollar compared to the yen, it would take action to lower that ratio, perhaps seeking to create a situation where, hypothetically and unrealistically, the U.S. dollar was worth 125 yen. 

Reasons governments might devalue their own currency can include making their exports more cost-competitive globally or working to reduce deficits.

The end result, however, is that the currency in the country has less purchasing power, which can lead to inflation. 

Rising wages

When wages increase across large sectors of an economy, prices tend to go up. That's true whether governments enact new minimum wage laws or employers simply choose to raise wages so they can hire and keep good workers.

Companies that pay more to employees incur more costs. They typically pass those costs along to consumers in the form of increased prices. Again, this creates a situation where every dollar buys less due to inflation.

In extreme cases, this can lead to a cycle. Consumers may buy less because of inflation, leading to company losses that become layoffs. Unemployment affects taxes and reduces average earnings across the nation, which cuts back even more on buying power.

The housing market

Supply and demand in the housing market can drive inflation overall. That's due in part to the fact that housing expenses make up such a large part of the average American's monthly expenses. If that one expense rises, the entire budget may need tweaking.

Here's one example of how the housing market can lead to inflation:

  • More people rent. This could occur if there aren't enough homes for sale to meet demands, or rising mortgage rates push people out of the home-buying market. 
  • Rental rates go up. Because there's a large demand for rentals — one that might outpace the supply — landlords could charge more for each rental. 
  • People spend less in other areas. People may cut down on discretionary spending to cover housing. 
  • Companies raise prices. Companies that see a reduction in revenue due to decreased discretionary spending raise prices to support profitability. The cycle eventually leads to overall inflation. 

How to measure inflation

Inflation is measured via a number of economic tools.

Consumer Price Index (CPI)

Perhaps the most widely used and well-known measure of inflation is the Consumer Price Index. The CPI measures the cost of a variety of goods to understand the overall impact of pricing in the marketplace.

The United States creates a CPI for each period based on the Consumer Expenditure Survey.1 This survey determines what types of goods and services are included in the CPI basket and how much weight each is given. The CPI is generally based on:

  • Food and beverages
  • Transportation
  • Housing
  • Medical care
  • Recreation
  • Other types of goods and services

Economists apply specific formulas to these data points to come up with the CPI. The CPI is then used as an overall metric to understand what is happening with inflation. 

Producer Price Index (PPI)

The Producer Price Index looks at pricing changes relevant to domestic producers, which are manufacturers and other businesses making products in the United States. Where the CPI looks at the prices consumers pay for goods, the PPI looks at the prices manufacturers and others get for their goods. That means this is an index concerned mainly with wholesale pricing. 

Even though the PPI doesn't take consumer pricing directly into consideration, it can be a good measure of overall inflation. That's because increased supply at the wholesale level eventually trickles down to increased supply everywhere else. The PPI does have some limitations, as it only considers domestic producers, which is not an entire picture of the economy.

GDP Deflator

The GDP deflator looks at the price of all goods and services that are produced within a single country, including any goods that might be for export to other nations.

Unlike the CPI, which is based on a basket of goods that is fixed, the GDP deflator considers all goods and services that are produced or provided within the country. This can provide experts with a more comprehensive understanding of how the economy and pricing are changing over large periods of time.

The GDP does not consider imports if those imports are direct consumer goods. Imports of raw materials or supplies required for goods produced within the country are considered indirectly, as they impact the costs of those goods.

Personal Consumption Expenditures (PCE) Price Index

The Personal Consumption Expenditures Price Index is similar to the CPI. It's based on a fixed basket of goods and services and includes many of the same items as the CPI. However, the PCE weighs the goods differently, putting more emphasis on medical care and miscellaneous goods and services and less emphasis on housing and transportation.

The PCE is used by the Federal Reserve to track inflation. The Federal Reserve can act to control inflation, to a certain degree, with economic policy and changes to interest rates. Overall, the Federal Reserve tries to keep inflation to around 2% annually.2

4 tips to protect against inflation

While individuals can't do a ton to combat inflation in the overall economy, they can take personal steps to protect their own finances. Obviously, it's a good idea to understand what is driving inflation, because that helps you know which goods and services may see price increases. Outside of educating yourself, here are four ways you can protect your finances in times of inflation. 

  1. Diversify your portfolio. A great way of managing inflation in your investment returns and portfolio is to diversify. That means you put your money into a variety of investments with the hope that some of them will perform decently at any given time even if others aren't. Some buckets to consider investing in for a globally diversified portfolio include stocks, bonds, and alternative investments such as real estate, gold, and other diversified commodities.
  2. Limit your cash savings. While it's certainly important to plan ahead for emergencies and have cash on hand for unplanned expenses such as a car breaking down, a trip to the emergency room, or even the temporary loss of a job, maximizing traditional cash savings isn't a great way to build financially for the future. Once you have an emergency fund in place, it's better to concentrate on investing in other opportunities. That's because the interest you earn on traditional or even high-yield savings accounts doesn't keep up with inflation generally — and certainly not when inflation is high. If you aren't earning interest on your savings equal to or above inflation, you are actually losing buying power in the future. 
  3. Do the math on your debt payoff plan. The same principle may apply to paying off debt. Yes, it's important to have a plan to pay off your debt, and you want to keep up with payments and balances to maintain a strong credit score whenever possible. However, if you're aggressively paying off debt to the degree you don't have enough money to save or invest, you might want to rethink your plans. That's especially true if your debt has a low enough interest rate. It's possible you could invest some of those funds instead, earning at a higher interest rate than you're paying in debt so you come out ahead in the future. Since inflation tends to go up over time, that also helps you have more spending power in the future.
  4. Take steps to increase your income. The only way to truly triumph over inflation when it comes to purchasing power is to increase your income. Increasing how much you make at a rate that equals or exceeds purchasing power means you can continue to buy the same amount of goods and services, even when prices rise. Some ways you can increase income include preparing yourself for better job opportunities via education or learning new skills, asking for cost-of-living increases, working a second job, or joining the gig economy.

Who benefits from inflation?

While inflation can hit your wallet, some investors and others do benefit from it. Here's a quick run-down of times when rising inflation can have a positive impact.

  • Homeowners or those with fixed-rate mortgages: If you own your home outright, you avoid issues of rising housing costs associated with inflation. You may also benefit if your property value rises. The same is true for people with fixed-rate mortgages. Their mortgage payment remains the same, but is actually becoming cheaper when adjusted for inflation. Assuming the homeowner is also able to enjoy steady increases to their income, they will enjoy an increased capacity to save or keep up with rising prices in other areas.
  • Stock and commodities investors: In general, the same forces that drive up prices of consumer goods may drive up the value of businesses and other investment assets. That can lead to positive returns on stocks or other alternative investments. However, there is not an asset class that will always outperform in every inflationary environment. Since all asset classes will fall in and out of favor frequently, it's important to stay diversified.
  • Certain industries: Businesses in specific sectors—typically those that provide necessary goods and services — benefit somewhat from the rising prices associated with inflation. That can include the energy and food sectors.
    Anyone with fixed-rate debt: Homeowners aren't the only ones that benefit from having fixed-rate debt as inflation rises. The money you borrowed before inflation rose was worth more than the money you pay back the debt with. 

Our take

Inflation will never go away. It's part of any economy and something investors and consumers will have to deal with now and in the future. While fast-rising inflation is certainly not what most people want to see, there are steps you can take to combat it in your financial life.

One of the best ways to create financial stability that can outlast rising inflation and other economic issues is to start investing and building for the future.

1 U.S. Bureau of Labor Statistics, “Consumer Price Index,” March 2022.

2 The Federal Reserve, “Why does the Federal Reserve aim for inflation of 2 percent over the longer run?”, August 2020.

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