No one wants to take a pay cut, but inflation often leaves Americans with no choice.
Americans emerged from the COVID-19 pandemic lockdowns with cash to spend and the desire to spend, but inflation posed a real threat to household incomes and the overall economy for the first time since the 1980s. Inflation is an economic phenomenon notorious among policymakers, investors, and consumers alike. According to the National Bureau of Economic Research, prices have risen 21.2% since February 2020, when the pandemic recession began. This means that Americans will need about $1,212 to buy the same goods and services that originally cost $1,000. These small changes add up over time, and over a 12-month period, the extra costs can total $2,544.
Rising inflation not only makes home prices higher, it also makes it harder to save for emergencies and invest for retirement. Needless to say, Federal Reserve officials are rapidly raising interest rates to curb the rising cost of living in the United States, even at the risk of triggering a recession and a slowing job market.
But not all inflation is bad inflation – prices across the economy are always rising and falling due to factors related to supply and demand. Here we explain what inflation is, what it isn’t, and why it matters so much to your wallet.
Latest insights on inflation
- Latest YoY inflation rate (August 2024): 2.5%
- Excluding food and energy: 3.2%
- The Fed’s official inflation target: 2%
What is inflation?
Inflation occurs when the costs of items that consumers purchase regularly, from services like haircuts and medical care to goods like appliances and furniture, increase over a long period of time. Inflation doesn’t happen overnight, and it doesn’t happen when the prices of certain products increase.
For example, say you go to the grocery store and buy a dozen eggs for $2. The next week, the same item costs $4. This price increase alone doesn’t constitute inflation, because prices within the monetary system are constantly fluctuating, especially the cost of food and energy. Inflation has a much broader perspective.
“You might see prices going up for certain items like gasoline or milk, but unless prices are increasing across a range of products and services, that’s not necessarily inflation,” said Jordan Van Rijn, a professor of agricultural and applied economics at the University of Wisconsin’s Center for Financial Security.
How much inflation is excessive?
Every year, prices should rise across the U.S. economy. Some inflation is seen as a sign of a healthy economy, helping businesses keep hiring and consumers’ paychecks growing. Fed officials aim for 2% inflation per year, which is currently the commonly agreed-upon level for inflation.
“Basically, it allows the economy to slowly raise prices,” said John Cunnison, CFA, vice president and chief investment officer at Baker Boyer Bank. “It allows businesses to slowly raise wages for their employees — just the right amount of inflation, not too little, not too much.”
But wallet-damaging inflation occurs when prices rise much faster than 2% and Americans’ paychecks can’t keep up. Consumers end up making tough decisions about what to buy and what to forgo. When inflation is affecting major necessities, consumers have no way to escape price pressures and may turn to credit card debt. Unpredictable price increases are also a problem for the economy, making it harder for businesses to price and plan for the future.
How to measure inflation
There are two main ways to measure inflation.
- Bureau of Labor Statistics Consumer Price Index (CPI)
- The Commerce Department’s Personal Consumption Expenditures (PCE) Index.
The CPI is primarily important to consumers: the BLS regularly provides information on how prices are changing for about 400 individual items, such as peanut butter and stationery. The Social Security Administration (SSA) uses a subset of the CPI to determine annual cost-of-living adjustments (COLAs), and the Internal Revenue Service (IRS) even uses the CPI in adjusting federal tax brackets. Because of this, the index is important to hundreds of millions of Americans.
Meanwhile, PCE is crucial to the Fed, but still has a large, albeit indirect, impact on consumers. Policymakers use it to decide what to do with key benchmark interest rates going forward, which affect how much consumers pay for borrowing. Officially, they target PCE, not CPI.
This preference is important because the two indices paint different pictures of inflation. While both measures capture the same trends, historically the CPI has tended to grow at a higher rate than the PCE. This is mainly because the indices use different formulas and weightings to calculate inflation. For example, housing is considered one of the most important items in the overall CPI index, but it also happens to be the hottest area for inflation right now. That may be why prices rose 2.9% year-over-year in July, according to BLS calculations. This is 0.4 percentage points higher than the PCE’s overall inflation rate of 2.5% last month.
Meanwhile, the CPI looks only at the amount consumers pay for a particular good or service, while the PCE looks at both consumer data and business spending. PCE also takes consumer substitution into account. For example, someone who substitutes seafood for meat one month because it is cheaper may not perceive food costs as high.
How economists track inflation
To get a broader picture of inflation, economists typically track year-over-year changes in overall price index levels, which can filter out temporary spikes and dips and seasonal factors, or analyze three- and six-month moving averages to identify recent trends. Meanwhile, excluding food and energy categories, which tend to be more volatile, gives us an idea of underlying inflation, often referred to as “core” prices.
How consumers track inflation
However, household perceptions of the U.S. economy are quite different.
First, many people tend to focus on price levels rather than rates of change. For example, slowing inflation doesn’t mean prices are falling, it just means they’re not rising as rapidly as they used to. Consumers who remember how much it cost to buy a cart of groceries or fill up their tank of gas may still be feeling the pain of inflation.
However, not all households buy the same goods. Because the inflation rate a consumer experiences varies depending on what they buy, their personal inflation rate can be lower or higher than the overall index. For example, car drivers may feel inflation harder than those who use public transportation because insurance and repair costs continue to rise. And households who send their children to college or pay medical bills may feel inflation even harder. These two areas are outpacing the overall inflation rate.
What causes inflation?
Economists categorize inflation into two main sources: demand-driven inflation and cost-push inflation. These terms sound strange, but they reflect an experience that many Americans are familiar with, especially since the coronavirus pandemic began.
But there may be other forces at work that don’t fit clearly into any of the categories. And, as has been the case since the pandemic, all these inflationary forces may intersect, creating pricing problems that are even harder to solve.
1. Cost-push inflation
Cost-push inflation occurs when prices rise because of higher production costs, such as rising wages or rising raw material prices. Businesses pass on these increased expenses by raising prices, which then trickles down to the cost of living.
Real-world examples
Higher lumber prices, higher energy and electricity bills, and rising food costs in the wake of the pandemic have forced builders, factories and even restaurants to raise prices.
2. Demand-Driven Inflation
Demand-driven inflation, on the other hand, occurs when consumers have a strong interest in services and goods. This demand stems from low unemployment, strong consumer confidence, low interest rates, etc. However, businesses can’t always keep up with that demand, leading to product shortages and resulting price hikes.
The economy could grow too quickly and fall into demand-driven inflation, resulting in too much money and a shortage of goods and services.
— Greg McBride, Chief Financial Analyst, Bankrate
Real-world examples
Huge demand and savings built up during lockdowns have driven up prices for experiences consumers were deprived of, like travel, concerts, sporting events and dining out.
3. Expectations of rising inflation
Even the expectation of rising prices can be a bad omen. When consumers start to expect rising prices, they are more likely to panic buy or demand higher wages. These two forces combine to create the very phenomenon that consumers were worried about.
“If people think inflation is going to be high, prices will continue to rise,” Van Rhein says. “If you’re an executive at a company setting wages, your job is partly driven by your expectations of how much prices are going to rise next year. When wages rise, the same thing happens to companies: they start raising prices.”
Real-world examples
As consumers try to catch up on massive post-pandemic price hikes, workers said a higher wage is the most important qualification in future employment in a Bankrate 2023 survey. In Bankrate’s 2024 Job Security Survey, more than two in five workers (43%) said they are likely to ask for a pay raise at some point in the next 12 months.
| Factors driving inflation | Factors cooling inflation |
|---|---|
| An increase in consumer or government spending, especially spending that involves debt | Cuts in consumer or government spending |
| Increase in money supply | A decrease or slowing growth in the money supply |
| Deficit spending, i.e. cutting taxes without cutting government spending | A government surplus, i.e. tax revenues exceed expenditures |
| Interest rates below the neutral rate of inflation or an increase in the money supply | Interest rates above the neutral inflation rate or a decline in the money supply |
| Highly integrated industries that push through higher prices or pass on higher costs to their own companies | A fragmented industry with little pricing power |
| A wage-price spiral in which rising wages drive up the prices of goods, leading workers to demand higher wages to compensate | Consumers saving more than they did before, or the net savings rate increasing |
| Expectations of higher inflation in the future | Expectations of lower inflation in the future |
| A supply shock that causes a sharp decline in production, such as the oil shocks of the 1970s | Supply will likely increase rapidly due to technological innovation |
| An improving job market and rising employment have boosted consumer demand | The weak demand is likely due to rising unemployment and the economic downturn. |
A brief history of inflation in the United States
The last time high inflation was a major problem was in the 1970s and 1980s, reaching 12.2% in 1974 and 14.6% in 1980, when central banks did not sufficiently curb demand by raising interest rates during a period of rising government spending and two oil price shocks.
Then-Federal Reserve Chairman Paul Volcker made major changes to how the Fed set interest rates, deciding to raise borrowing costs to the 19-20% range, the highest ever target range for the federal funds rate. Unemployment soared and the economy faced its worst recession since the Great Depression. But, painful as it was, the strategy was successful. Inflation rates fell steadily throughout the early 1980s, dropping to 1.2% in December 1986.
Inflation hasn’t been much of a threat since then, until now. Prices rose an average of 2.4% per year from 1990 to the end of 2019, and inflation as we came out of the 2007-2009 Great Recession was tepid at best, despite ultra-low interest rates. Economists largely blame the slow recovery after the financial crisis, as well as other disinflationary factors like globalization, technological change, and an aging population. But consumers might be surprised to recall that the Fed actually feared too-low inflation, thinking it could make it harder to stimulate the economy if a recession occurred.
What’s the latest on inflation?
Check out Bankrate’s analysis of where prices are rising the most right now and what’s the most expensive since the pandemic.
read more
Types of extreme inflation
While runaway inflation is always painful, there are other price pressures that are even more dangerous to the economy and Americans’ purchasing power.
1. Stagflation
Stagflation occurs when rising unemployment, slowing demand, and economic growth slow without inflation. Slowing growth and rising unemployment are usually inversely related to inflation. Lower wages put pressure on spending, and lower spending makes it harder for businesses to expand and invest.
This kind of inflation only occurs under certain conditions. It is usually driven by a supply shortage that continues to strain the productive capacity of the U.S. economy. There are also different degrees of stagflation. In the worst-case scenario, inflation can skyrocket and the financial system can fall into recession. In milder, but still painful, cases, growth may simply be mediocre.
Either way, the environment is particularly tough because raising interest rates — the traditional way to curb inflation — is unlikely to have an immediate effect.
2. Hyperinflation
Hyperinflation occurs when prices rise dramatically, sometimes by as much as 50 percent per month — think Germany in the 1920s or the current economies of Venezuela and Zimbabwe — but it only occurs when a combination of poor policymaking occurs, from an explosion in government spending and debt to a rapid increase in a country’s money supply.
How consumers can protect themselves against inflation
- Find the best places to store your cash: Inflation isn’t all bad, but it’s bound to hurt consumers who hide their money under their mattresses or in brick-and-mortar banks. Historically, investing in money markets has been the best way to grow your purchasing power over time, whether you’re 50 years or 50 days away from retirement. Meanwhile, high-yield savings accounts currently offer annual percentage rates (APYs) of 5 percent or more that beat inflation.
- Stick to your budget: Times of high inflation highlight the importance of keeping a tight grip on your budget. Make sure you know how much you are spending and how much you can afford to spend.
- Find the most affordable option: It’s hard to escape inflation when prices are rising across the board, but using technology to find the cheapest products on the market and compare your options can lead to big savings in the long run. Even better, look for coupons or see if retailers are price checking.
- Have an emergency fund ready: Consumers may think it’s unwise to hold too much cash when they fear their purchasing power will decline, but that’s when they should focus and build cash reserves where they need them most. Higher inflation means higher interest rates, raising the risk of a recession and the cost of credit card borrowing.
