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Smart Money

What Is Inflation?

Inflation is the general rise of prices over time and is measured by tracking changes in the price index. Learn more about what inflation means for you.

Sarah Li Cain • November 8, 2022

It’s not only you: almost everyone is feeling the squeeze in their budget these days. 

More specifically, we’re all feeling the impact of worsening inflation – according to the Bureau of Labor Statistics’ latest report, the inflation rate in October was 8.2% as measured by the consumer price index,¹ which hasn’t been this high since the 1980s. 

We’re here to help you understand the details of inflation and how it affects your spending power.

What causes inflation?

Inflation is the general rise in the prices of goods and services over time that affects your purchasing power. Essentially, your money won’t go as far as it would have in the past. For example, you may have been able to buy a dozen eggs at the grocery store for $1.50 ten years ago, but today it costs $2.50. 

Inflation is caused by many factors which fall under two types: demand-pull inflation and cost-push inflation.

Demand-pull inflation

This type of inflation happens when there is an increase in the demand for goods and services that is more than the economy’s production capacity. It’s usually due to an increased supply of money and credit, which can heavily affect the conditions in which demand goes up, leading to price increases. 

In other words, when people have more access to money, it usually makes them feel more confident about their spending. This increased spending creates a rise in demand which could “pull” higher prices, especially when there isn’t enough supply.

For example, there was a semiconductor shortage in 2021, and combined with the increase in vehicles, auto companies found it hard to keep up with manufacturing demands.² As a result, the shortage of new vehicles meant that prices of new and used cars went up. 

Cost-push inflation

Cost-push inflation happens when overall prices for goods and services go up because of higher production costs and wages. Basically, if the prices of raw materials or other manufacturing costs are higher, companies may try to push these extra costs onto consumers.

For example, if the price of lumber goes up, companies that use lumber may increase the prices of their goods. Or, if companies increase wages to maintain skilled workers, the extra expense could translate to higher prices if the company wants to remain profitable. In addition, new laws requiring employers to pay increased benefits or follow stricter regulations could lead  to increased prices of their products and services. 

How inflation is measured

Inflation is measured by gathering data — namely, the prices for a wide variety of goods and services at a given point in time. These goods and services are typically representative of those many people consume, including housing and energy costs. 

The prices of these goods and services are lumped together into a “basket,” referred to as a price index. Then, statistical agencies like the Bureau of Labor Statistics and Bureau of Economic Analysis look at how much the basket would cost today and how much it would cost over a period of time. 

By comparing the changes in the price index over time, statistical agencies can then measure the rate of inflation, whether that’s monthly or annually. 

The consumer price index

The consumer price index, or CPI, is one of the most widely used measurements of consumer prices in the U.S. It measures the changes in out-of-pocket spending for households in urban areas for certain goods and services. These are costs that consumers pay directly, like rent, groceries, and gas. 

The Bureau of Labor Statistics created the CPI and measures it monthly. 

The CPI isn’t the only measurement of prices. The personal consumption expenditures price index, or PCE, also measures changes in the prices of goods and services, but it looks at ones from all households and nonprofits that serve them. It also has a wider range of consumer goods and services. Though both use different data types, their measurements tend to be very similar.³

Why is inflation so high?

Inflation is a natural part of the economy. Unfortunately, we’re seeing high rates of inflation that we haven’t really seen since the 1980s. The rising inflation is related to the events of the last few years.

When the pandemic upended the economy, businesses closed or were forced to cut their hours. Employers cut many jobs and stopped or lessened their overall production. 

To help boost the economy, the U.S. government provided financial aid through the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Many unemployed people received higher-than-normal unemployment checks, and households received Economic Impact Payments (better known as stimulus checks).  

The Federal Reserve also intervened by slashing interest rates to 0%4 in the hopes that spending levels would remain at a steady pace through the lower cost of borrowing. This infusion of cash made consumers feel more confident in their spending. The demand rose for certain goods, leading to price increases.

Once vaccines started rolling out and restrictions weren’t as strict, many consumers returned to restaurants, bars, and travel destinations. Due to this increased demand, businesses found it hard to purchase enough supplies or find enough workers to handle orders. 

Global and domestic supply chains were disrupted and supply was down, leading to higher prices. Companies ended up passing on their extra costs to consumers.

When will inflation go down?

It’s hard to tell when inflation will start to go down. For now, if businesses are still struggling to keep up with consumer demand, high rates of inflation could continue. As of October 2022, the unemployment rate is at 3.5%5 and there are 10.1 million job openings.6 Even though these data signal that there are plenty of jobs and people are working, it doesn’t mean that everyone can afford the soaring costs of items, especially necessities. 

The Federal Reserve is trying to combat inflation by aggressively increasing interest rates – higher borrowing costs hopefully mean people will spend less, or demand will go down. Plus, the high rate of inflation could mean that many are already trying to spend less, which could lower demand over time. 

FAQs

How does raising interest rates help inflation?

The Federal Reserve is responsible for controlling rates to help maintain a low inflation rate. Raising interest rates means that it’ll generally cost more to borrow money. For instance, the APR on your credit, or variable rate mortgage will go up. If you want to purchase a new car, you could also see higher rates on auto loans.

The idea is that, by increasing the costs to borrow money, The Federal Reserve can encourage consumers tospend less and lower demand, leading to prices remaining constant or even going down.

How do you calculate the inflation rate?

The inflation rate is calculated by measuring the changes in the price index over a period of time, such as monthly or annually. The Consumer Price Index is most common measure of the inflation rate. 

What's in the Inflation Reduction Act?

The Inflation Reduction Act, signed by President Biden in August 2022, lowers certain costs in an effort to tackle rising inflation. The bill includes investments in climate protection like tax credits to help offset energy costs, allowing Medicare to negotiate prices of certain high-cost drugs, and lowering health insurance premiums under the Affordable Care Act.7

Why is inflation bad?

Inflation is bad because it reduces your purchasing power and lowers the value of your money. For instance, you won’t be able to buy $10 worth of items today that cost $10 a few years ago. The price would be higher due to inflation.

Don't let inflation get you down

Yes, inflation may be high right now, but that doesn’t mean all hope is lost. There is evidence that prices are going down or stagnating, so hopefully inflation will gradually slow. 

Plus, there are also things you can do to help you adjust to rising costs. You can take advantage of high-yield savings accounts (yes, rates go up for those, too), score promotional deals at your favorite retailer, or find ways to increase your income.

The Federal Reserve’s aggressive moves to raise rates to combat inflation will ideally lower demand, helping to lower inflation in time.  

Need to save money? Open a High-Yield Chime Savings Account to earn interest on your savings. Take advantage of Automatic Savings features to help reach your goals faster.

Are you feeling the hit on your finances? Check out our top recommendations to grow your income during inflation.

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1 Information from Bureau of Labor Statistics News Release: Consumer Price Index - September 2022 as of October 25, 2022: https://www.bls.gov/news.release/pdf/cpi.pdf

2 Information from McKinsey’s Coping with the auto-semiconductor shortage: Strategies for success as of October 25, 2022: https://www.mckinsey.com/industries/automotive-and-assembly/our-insights/coping-with-the-auto-semiconductor-shortage-strategies-for-success

3 Information from Federal Reserve Bank of Cleveland’s Consumer Price Data as of October 25, 2022: https://www.clevelandfed.org/center-for-inflation-research/consumer-price-data

4 Information from the Federal Reserve’s Open Market Operations as of October 25, 2022: https://www.federalreserve.gov/monetarypolicy/openmarket.htm

5 Information from the U.S. Bureau of Labor Statistics News Release: Employment Situation Survey as of October 25, 2022: https://www.bls.gov/news.release/empsit.nr0.htm

6 Information from the U.S. Bureau of Labor Statistics News Release: Job Openings and Labor Turnover Summary as of October 25, 2022: https://www.bls.gov/news.release/jolts.nr0.htm

7 Information from the White House Fact Sheet: The Inflation Reduction Act Supports Workers and Families as of October 25, 2022: https://www.whitehouse.gov/briefing-room/statements-releases/2022/08/19/fact-sheet-the-inflation-reduction-act-supports-workers-and-families/

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