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5 Effects Of Inflation On The Economy

9-Minute Read
Published on July 20, 2023
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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 ways. Let’s explore what impacts you can expect to see when inflation is on the rise.

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.

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.

1. 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 effect 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.

2. Higher Interest Rates

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

The average consumer takes advantage of borrowing to make major purchases, like a home or vehicle, a reality. This means rising interest rates impact household purchases across the country. If you have any debt with a variable interest rate, you’ll face higher costs as your interest rates increase.

3. Higher Prices For Everything

When everything is more expensive, the impacts are felt by everyone. 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.

4. 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. The cost to borrow money is intentionally increased with the hope that this will decrease consumer spending and slow inflation.

However, consumers looking to make major purchases will find this challenging. Since most need credit to make a major purchase, the end result is that it slows down the economy.

5. 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.

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.

Let’s take a look at some of the ways in which inflation can have both positive and negative impacts.

Why Is Inflation Bad?

In general, inflation is considered a bad thing for many consumers. Typically, those with low incomes or fixed incomes feel the impact of inflation the most.

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 monthly food bills or utility bills start to rise.

The reality is that rising costs don’t necessarily equate to rising wages, which means many households face challenging times when inflation is on the rise.

As prices begin to tick upward, some start tightening their budget. However, if you do have the money to invest during times of economic downturn there’s potential for long-term gains. Since higher interest rates can eventually translate to higher returns, investors look to stable low-risk investments like treasury bonds, securities, and high-yield savings accounts.

The spending trend can push prices even higher, and the markets can be slow to catch up to the changing consumer demands. For example, often the housing market still sees high housing prices even when sales are slowing.

If inflation gets too high, it can be painful for everyone as the Fed tries to control the trend 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. As a benchmark, 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 low or the economy is in a recession, 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 stays 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 this scenario, the short supply is what causes prices to rise.

Over the past few years, the 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. The 2022 war in Ukraine further affected inflation causing a surge in the cost of fuel and food prices.

Supply chain shortages have begun to rebalance 2023 with an overall slowdown in the rate of inflation for food and fuel. The cost of basic services like transportation, rent and food remain high meaning many consumers have less money to spend on non-essential items.

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.

As quarantine and travel restrictions were lifted during 2022 and entering 2023, demand increased in sectors such as travel and entertainment. As a result, suppliers that scaled back on spending in these industries need to offer higher wages and rehire workers, causing the costs of these services to steadily increase.

Though demand-side inflation has cooled down compared to supply-side inflation, it’s still relatively high across the board due to rising interest rates. This is particularly true in the housing sector where mortgage rates remain high even as housing prices level out.

What Is Happening With Inflation Rates Right Now?

As of April 2023, the Consumer Price Index (CPI) indicates that the cost of consumer goods has risen by 4.9% over the last 12 months. That’s down from 8.5% in July 2022. Historically, a few of the costs driving the high CPI include rising energy prices, and unique supply chain issues caused by the pandemic. Though inflation rates have slowed in 2023, the indexes for shelter, energy, new vehicles and more have continued to increase at a slower pace.

In comparison to the unacceptably high inflation rates of 2022, the outlook for 2023 is already much improved. The Fed made a series of interest rate hikes to help regulate inflation. It’s expected that the Fed will continue to raise interest rates until the inflation rate cools.

Though housing prices remain high in many urban areas, the first quarter of 2023 saw quarterly declines in both the mortgage market and home prices. With high prices for construction materials and housing stock in short supply it’s hard to say for sure if the price-cooling trend will continue for the rest of 2023.

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 home buyers could be stuck with higher costs and limited options.

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.

Groups That Benefit From Inflation

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.

Groups That Don’t Benefit From Inflation

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 will likely reduce excess spending. When prices are through the roof, consumers will likely think twice before purchasing big-ticket items. 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 rises.

The Bottom Line: Know The Good And Bad Sides Of Inflation

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. Though inflation is still rising, the recent slowdowns and improvements in the housing market are encouraging.

As a home buyer, it’s still unclear whether the demand for housing might be affected in the coming months. However, the decision to purchase a home doesn't always hinge on the housing market. If you’ve outgrown your home or are looking to make a life change, it’s still possible to make homeownership a reality.

Ready to start your home buying journey? Get started online and see what you qualify for. 

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Sarah Sharkey

Sarah Sharkey is a personal finance writer who enjoys diving into the details to help readers make savvy financial decisions. She’s covered mortgages, money management, insurance, budgeting, and more. She lives in Florida with her husband and dog. When she's not writing, she's outside exploring the coast. You can connect with her on LinkedIn.