Inflation: What It Is and Why It Matters

Inflation has an impact on the price of everything. Understanding what it is, why it matters and how to handle it can help when making financial decisions.

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What is inflation?

Inflation occurs when the price of goods and services increases over time. The result is a decrease in purchasing power, or value of money, as the years go by.

If you’ve ever heard someone say something like, “I remember when a soda pop only cost me a nickel,” there’s one big reason: inflation. Because of inflation, the price of a bottle of Coca-Cola has increased twelvefold since it debuted in 1886.

Because inflation affects the prices of everything around us, keeping tabs on how the rate of inflation is trending is important when making decisions about your money now, and in the future.

How to measure inflation

One commonly used inflation metric is the consumer price index, or CPI, calculated by the U.S. Bureau of Labor Statistics. The bureau measures CPI by monitoring the average change in prices paid for a variety of goods and services, classified by eight groups: food, housing, apparel, medical care, recreation, transportation, education and communication, and other goods and services.

There are other metrics that tell us about the inflation story, such as the personal consumption expenditures price index. PCE is calculated by the U.S. Bureau of Economic Analysis, which also prices a different basket of goods and services from the CPI basket.

You might hear of inflation described as headline or core. Headline inflation measures total inflation for a certain time period. Core inflation attempts to pinpoint a more accurate read on inflation by excluding food and energy prices, which can fluctuate widely on a daily basis.

Inflation calculator

You can calculate the rate of inflation by examining the percent change in CPI over a set time period.

Check out our handy inflation calculator to see the impact of inflation on the value of your money.

Types of inflation

There are many types of inflation, characterized by either its cause or the rate of increase.

  • Cost-push. A common cause of inflation is when the cost of producing goods and services increase and push prices higher. This can happen when prices of raw materials or labor costs rise.

  • Demand-pull. Another cause of inflation is when the demand for goods and services outstrips what can be produced at the time, making prices go up.

  • Deflation. The opposite of inflation — a negative inflation rate or a drop in prices of goods and services.

  • Disinflation. A falling rate of inflation or slowdown in the rise in prices of goods and services.

  • Reflation. A way to curb deflation, when a government purposely stimulates the economy by increasing the money supply or government spending — such as the COVID stimulus payments. Reflation can also happen when a government lowers interest rates.

  • Creeping. Low or mild inflation with prices rising less than 3% a year.

  • Walking (trotting). Prices rise moderately, but the annual inflation rate stays in the single digits.

  • Running (galloping). Prices increase significantly into the double digits, above 10% a year.

  • Hyperinflation. Extraordinary inflation spiraling out-of-control, over 1,000% a year.

  • Stagflation. High inflation even during an economic downturn.

Why inflation matters

The impact of inflation is felt throughout an economy. As prices rise, what you can buy now will lessen over time. Being able to combat, or at least keep up with, inflation and sustain the purchasing power of your money is one of the main reasons to invest your money.

Consumers care about inflation because it affects costs and their standard of living. Businesses carefully watch the price of raw materials that go into their products, as well as what wages they need to pay their employees. Inflation affects taxes, government spending and programs, the level of interest rates and more.

A low, steady or predictable level of inflation is considered positive for an economy. It signals growth and healthy demand for goods and services.

As businesses generate more goods and services to keep up with demand, they need to hire more workers, which generally leads to higher employment and wage growth. Those workers then purchase things they need and want, and the cycle continues. However, when inflation gets too high or too low, it becomes dangerous because it’s hard to keep supply and demand, along with economic growth, in check.

This brings us to the importance of investing. Although you’ll earn interest from the bank on money in your savings account, the interest rate you receive usually won't match or even come close to beating the inflation rate. That’s why it makes sense to invest your money, if you can afford to, and grow that money’s value over time. That way, you can buy the same amount of goods and services in the future.

When creating a plan to reach your financial goals, it’s important to bake in a realistic inflation rate for future expenses so you’re saving enough to meet your needs.

U.S. inflation rate

Looking at CPI for the 30 years from 1989 to 2019, the average annual inflation rate was 2.5%. The Federal Open Market Committee, the arm of the U.S. central bank that makes decisions about managing the nation’s money supply, targets a 2% rate of inflation over time.

The prices of different good and services can rise at different rates. For instance, education and health care costs are generally subject to higher inflation rates than the average inflation rate.

According to finaid.org, a site that offers financial aid advice, tools and information, U.S. tuition rates are typically more than double the general inflation rate, and on average, increase about 8% each year.

And according to the Centers for Medicare and Medicaid Services, national health spending is projected to grow at an average annual rate of 5.4% between 2019 and 2028.

How to protect against inflation

Avoid hoarding cash

To make sure your money doesn’t lose too much value, it’s important to invest and not keep too much money in cash, Tony Molina, senior product specialist at Wealthfront, said in an email interview.

“The impulse to hang onto as much cash as possible is an understandable one, and it can feel reassuring to accumulate more of it in challenging situations as a buffer against unexpected events,” he said.

However, inflation means your money will probably buy less over time. Molina suggests investing the money you don’t intend to use in the next three to five years, so that you can avoid a decrease in purchasing power.

Diversify your portfolio

Another way to prepare for inflation is by having a well-diversified investment portfolio. Diversification, when you spread your investments across asset classes (stocks, bonds, cash, real assets, etc.), various industries and countries, helps enhance investment returns while simultaneously reducing risk, such as from inflation.

There are certain investments that are more inflation-tolerant than others or rise together with inflation, Eric Leve, chartered financial analyst and chief investment officer of Bailard, a wealth management firm in San Francisco, said in an email.

Leve recommends including some of these natural inflation hedges as part of your overall portfolio to help defend against inflationary times, such as:

  • Real assets. Assets such as gold or real estate, which retain value or provide pricing power, help withstand inflation. For example, landlords sometimes raise rents as inflation rises.

  • Stocks. Especially stocks with proven earnings growth and low debt. Interest rates tend to rise with inflation, causing companies with high debt to face higher payments.

  • Treasury Inflation-Protected securities. During inflationary times, rising interest rates negatively impact traditional bonds because bond prices and interest rates have an inverse relationship. TIPs are a type of bond indexed directly to CPI meant to help investors preserve purchasing power.

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Ask for help

Making sure your investments are set up to safeguard against inflation is important and there are many factors to consider. Seeking a second opinion from a financial advisor can be useful to ensure that you’re on the right track and have prepared your portfolio to weather all seasons of varying economic environments.

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