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5 Effects Of Inflation On The Economy

8-Minute Read
Published on September 22, 2022
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When inflation is on the rise, it’s more expensive to purchase goods and services. But the effects of inflation don’t stop with shoppers feeling the pinch on their wallets. The major trend impacts the economy in several different ways. Let’s explore what impacts you can expect to see.

Is Inflation Good Or Bad?

Inflation is measured by the consumer price index (CPI), and at low rates, it keeps the economy healthy. But when the rate of inflation rises rapidly, it can result in lower purchasing power, higher interest rates, slower economic growth and other negative economic effects.

What Is Inflation?

According to the U.S. Department of Labor, inflation is defined as a “general upward price movement of goods and services in an economy.” In other words, life gets more expensive as the cost of making purchases rises.

Why Is Inflation Bad?

In general, inflation is considered a bad thing for an economy.

When the costs of goods and services rise, everyone’s wallets feel a little bit pinched. You might have seen the impacts of inflation for yourself when your normal grocery basket starts to get more expensive.

But the reality is that rising costs don’t necessarily equate to rising wages, which leaves many households across the nation to face challenging times when inflation is on the rise. Typically, those with low incomes or fixed incomes.

When inflation is on the rise, consumers can’t help but notice the changes. As prices begin to tick upward, while some start tightening their budget, many turn up the heat on their spending and investing. After all, many realize that their dollars are going to be worth less tomorrow than they are today.

The spending trend can push prices even higher. And the markets can be slow to catch up to the changing consumer demands. For example, the housing market is still seeing high housing prices even though sales are slowing.

If inflation gets too high, it can be painful for everyone as the Federal Reserve (Fed) tries to tame it through tighter monetary policy and higher interest rates.

Why Is Some Inflation Good?

Inflation isn’t always a bad thing. In fact, the Fed considers a modest amount of inflation as a key indicator of a healthy economy. With that, the Fed strives to keep inflation at the 2% mark. This measure aims to keep the economy growing at a healthy pace.

The Fed uses several tools to accomplish its goal, including setting the Federal Funds Rate. When inflation is rising, the Fed increases interest rates to cool inflation. When inflation is too low, the Fed lowers interest rates with the hope that potential borrowers will be enticed to take out loans. For example, buyers might be enticed to buy a house or do a cash-out refinance to undertake home renovations. All of these choices help to fuel economic growth.

On the opposite end of the spectrum is deflation, which happens when the cost of goods or services falls over time. At first glance, this might seem like a reprieve to consumers. But deflation is sometimes fueled by a lack of demand, which can eventually cause unemployment to rise.

What Causes Inflation Rates To Rise?

Many factors can contribute to the rise of inflation. But generally, inflation can be a big issue when supply and demand are out of balance. For example, a limited supply of fuel would likely lead to rising gas costs if demand stayed the same. Additionally, a relaxed monetary policy with a larger money supply than the economy can reasonably support can push inflation higher.

Back in the early 1980s, the U.S. experienced a period of significant inflation as a response to the energy crisis. High inflation rates prompted the Fed to raise interest rates, culminating in the highest mortgage rate of all time on October 9, 1981, with the average 30-year fixed-rate mortgage interest rate at 18.63%.

Supply Side Inflation

Supply side inflation occurs when there’s not enough supply to meet the demand. In that scenario, the short supply is what causes prices to rise.

In the past couple of years, pandemic-caused shortages in high-demand products have seen significant inflationary pressure. For example, the limited supply of lumber made it more difficult to build a new house.

An analysis by the Federal Reserve Bank of New York found that 40% of the higher prices between 2019 and 2021 were due to supply-side issues.

Demand Side Inflation

On the other side of the coin, there’s demand-side inflation. When the demand for an item increases, that can cause prices to rise when supply stays level.

The Federal Reserve Bank of New York’s analysis found that 60% of the higher prices between 2019 and 2021 were due to demand-side issues. This demand side inflation is partially fueled by a looser monetary policy at the onset of the pandemic.

What Is Happening With Inflation Rates Right Now?

As of August 2022, the Consumer Price Index (CPI) indicates that the cost of consumer goods has risen by 8.3% over the last 12 months. That’s down from 8.5% in July 2022. Notably, a few of the costs driving the high CPI include rising energy prices and unique supply chain issues caused by the pandemic.

With inflation at unacceptably high rates, the Fed has made a series of interest rate hikes. It’s expected that the Fed will continue to raise interest rates until the inflation rate cools. Although home prices are still high right now, rising interest rates should eventually push the housing market into a buyer’s market.

What Does Inflation Do To The Economy?

As inflation rises, the impacts are pervasive.

For consumers, higher prices for regular goods and services mean tight times. That’s especially true when real income erodes over time because wages often don’t keep pace with inflation.

But there are two sides to every story. Sometimes, one side of a transaction benefits from inflation. For example, if it’s a seller’s market and housing prices soar, the seller could walk away with a tidy profit. But homebuyers could be stuck with higher costs and limited options.

5 Effects Of Rising Inflation Rates

Although it might only seem like the trend impacts your budget, inflation often has far-reaching impacts across the economy. Let’s explore the most prevalent effects of rising inflation rates.

Lost Purchasing Power

The most obvious impact of inflation is the loss of purchasing power. As purchasing power erodes, many feel the impacts on their budget. But those on a low income or fixed income often feel the pinch the most.

As inflation takes hold, it’s important to monitor how well your income keeps pace with the changes. If it’s within your power, negotiate for a raise or switch up your income streams to keep up with rising costs.

Higher Interest Rates

The Federal Reserve has a relatively limited toolkit to tame inflation. And the option they turn to first is usually raising interest rates. As the Fed pushes interest rates higher, it gets more expensive to borrow money.

Since the average consumer takes advantage of borrowing to make major purchases, like a home or vehicle, a reality, this has a big impact on households across the country. If you have any debt with a variable interest rate, you’ll face higher costs tied to the higher interest rates.

Higher Prices For Everything

When everything is more expensive, wallets are pinched. After all, it’s impossible to go without the basics such as food or electricity. But with rising costs, it can become more difficult to make ends meet.

The older and lower income wage earners are the first to feel the bite of higher prices. But eventually, it works its way up the income chain and begins to threaten companies or even entire industries.

Economic Growth Slows

As inflation runs rampant, the Fed tightens its monetary policy. With the money supply drying up, credit becomes more expensive and credit requirements tighten.

Again, consumers looking to make major purchases find this a challenge. Since most need credit to make a major purchase, this slows down the economy.

Anti-Inflationary Measures Can Cause A Recession

Inflation is a major threat to the economy. But as the Fed tries to adjust the market with monetary policy and interest rate hikes, sometimes it overcorrects.

If the market isn’t ready for the Fed’s actions, that can mean lower economic growth for the country. When this happens for one quarter, it is usually referred to as a contraction. But if this happens for two quarters in a row, it is generally considered the start of a recession.

During a recessionary environment, the Fed often lowers interest rates to encourage economic activity. But as the cycle continues, it can be a painful ride for everyone.

When Inflation Rates Rise: Some Benefit, Some Don’t

When it comes to the economy, somebody’s loss is somebody’s gain. Let’s take a closer look at those who may or may not benefit.

Those Who Benefit

It might be surprising. But some people do benefit from inflation. Here’s a look at those who do.

Homeowners

As a homeowner with a fixed-rate mortgage, you could benefit from the impacts of inflation. That’s especially true if you locked in a mortgage loan or refinanced a more expensive mortgage while rates were at historic lows in 2020.

They’ll have peace of mind knowing that your mortgage payment won’t go up with a low-interest 30-year fixed-rate mortgage. As inflation rises, their mortgage expense will be a smaller part of their monthly budgets.

Home Buyers

As interest rates rise, some home buyers are priced out of the market. But those that remain able to afford a home may start to notice less competition.

The lack of competition can help you get into a home. But higher interest rates will ultimately hurt your bottom line.

Those Who Don’t

Of course, not everyone benefits from inflation. Here’s who gets the short end of the stick.

Home Buyers

Home buyers appear on both sides of the equation. Although the lack of competition may be a welcome relief, higher interest rates mean that homeownership is more expensive overall.

For example, let’s say that you purchase a home with a $400,000 loan. As of August 30, 2022, the average interest rate for a 30-year loan was 5.98%. That leads to a monthly payment of $2,393.

In contrast, the average interest rate for a 30-year mortgage in August 2020 was 2.98%. That leads to a monthly payment of $1,682. With that, today’s home buyers are paying significantly higher monthly payments for similarly priced homes. 

Consumers

Consumers facing higher prices can feel the pain in their wallets. When they want to purchase a big-ticket item, it’s easy to think twice when prices are through the roof. As inflation rises, many consumers feel a lack of confidence in their ability to purchase major items, like a home or vehicle.

Fixed Income Workers And Retirees

As the costs of basic goods rise, inflation hits the budgets of fixed-income workers and retirees first. When on a fixed income, there’s little one can do about the rising costs except make sacrifices to impact your quality of life.

Many are forced to make difficult choices as inflation rears its ugly head.

The Bottom Line: A Little Inflation Is Good, But Too Much Can Hurt Markets

Like almost everything else, inflation is good in moderation. Although a low level of inflation is often good for an economy, high levels of inflation can make life more difficult for many. And the reality in our current economic climate is that inflation may get worse before it gets better.

As a home buyer, it’s unclear whether the demand for housing might be affected in the short term. But the decision to purchase a home doesn't always hinge on the housing market. If you’ve outgrown your home or want to take this major financial leap, it’s still possible to make homeownership a reality.

Want to move forward with homeownership? Apply online now for initial approval and lock in your home loan interest rate now.

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Sarah Sharkey

Sarah Sharkey is a personal finance writer that enjoys helping readers learn more about their finances. She has an MS in Business Management from the University of Florida. You can connect with her on LinkedIn or Instagram @adventurousadulting.