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How Inflation Works: Causes Explained

6-Minute Read
Published on September 12, 2022
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You might not know the technical definition of inflation, but most of us can feel the pinch on our wallets when inflation strikes. Inflation happens when the cost of goods and services rises over time. But how does inflation work behind the scenes?

Let’s take a closer look at inflation and its causes.

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What Is The Definition Of Inflation?

Inflation represents a measure of the rising costs of goods and services throughout the economy. As the cost of goods and services rises, the purchasing power of a single dollar decreases.

You might feel inflation in your own life when you notice that your dollar doesn’t stretch quite as far as it used to.

How Does Inflation Work?

Inflation generally occurs when the supply of goods and services can’t keep up with an increase in consumer demand for those goods and services – or when demand stays the same but the supply chain has become limited in some way. In either scenario, the cost of goods and services across the economy increases, which weakens your money’s purchasing power.

Inflation happens on a big economic scale. Rising costs across key sectors of the economy are a part of an inflationary environment. Across the country, consumers face a higher cost of living, which means that it’s more expensive to make ends meet.

For example, the average price of a single-family home in 2012 was $177,200. In the first quarter of 2022, the average price for a single-family home was $368,200. That’s a significant decrease in purchasing power.

A little bit of inflation is considered acceptable. In fact, the Federal Reserve’s target inflation rate is 2%. But sometimes, inflation can skyrocket past that benchmark number. If left unchecked for too long, inflation can do significant damage to everyone’s wallets.

One of the many impacts of inflation is how the Federal Reserve combats it. When inflation rises, the Federal Reserve raises interest rates to tame rising costs. Higher interest rates make borrowing costs more expensive for consumers.

Since one of the biggest purchases most of us finance is a home, higher mortgage rates as a result of inflation have a big impact on the housing market. Over time, inflation makes it more expensive for home shoppers to finalize their home purchases.

A bigger mortgage payment increases the cost of living for households across the nation. For example, the average monthly mortgage payment rose from $1,064 to $1,383 from 2021 – 2022. As a home shopper, that increase of several hundred dollars could make all the difference in your budget.

What Causes Inflation To Occur?

The result of inflation is higher prices that put pressure on everyone’s budget. But here’s a closer look at the causes of inflation.

Demand-Pull Inflation

When demand for goods and services increases faster than the supply, that pulls prices higher. The reason is that there’s not enough supply to meet the growing demand.

Cost-Push Inflation

On the flip side, cost-push inflation happens when the supply of a good or service is limited but demand remains the same. There’s simply not enough supply to match the demand, so prices rise.

For example, you might find higher prices at the grocery store after a natural disaster when there’s only a limited amount of food to go around.

How Is Inflation In The US Economy Measured?

The U.S. economy has several measures of inflation. Typically, economists look at each of the indexes together to get a better idea of inflation.

If you want to calculate the inflation rate of a particular good or service, you can use the following formula:

  • (Current Price − Former Price) ∕  Former Price

However, you’ll find a more comprehensive inflation estimate by looking at each of the indexes below.

  • Consumer Price Index (CPI): The CPI is tracked by the U.S. Bureau of Labor Statistics to measure how the prices of goods and services are changing for consumers. With a standard ‘basket of goods,’ a report is issued each month to determine whether the overall costs for consumers has gone up or down. The CPI includes factors like housing, groceries, clothing, transportation, medical care and more.
  • Producer Price Index (PPI): The U.S. Bureau of Labor Statistics uses the PPI to track the prices businesses receive for the goods or services sold each month.
  • Personal Consumption Expenditures Price Index (PCE): The Bureau of Economic Analysis tracks the PCE to report how much consumers are paying for goods and services. It’s similar to the CPI. But it includes more comprehensive items in its basket of goods that change over time to reflect changing consumer habits.

The Federal Reserve takes these numbers into account when determining whether or not to increase the federal funds rate in an effort to stabilize inflation.

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How Can You Protect Yourself Against Inflation?

The reality is that an inflationary environment isn’t fun. We all want to get the most bang for our hard-earned dollar, and inflation makes that more difficult.

Consider implementing the following strategies to avoid the biggest impacts of inflation.

Raise Your Salary

With the cost of living on the rise, negotiating for a higher salary could protect your standard of living.

Before approaching your boss with your request, do some research about your industry. Find out what your salary should look like. If you are being underpaid, bring data to the conversation to back up your request.

Purchase Bonds

Although bonds often offer lower returns than stocks, investing in bonds can help you beat inflation. Many risk-averse investors turn to inflation-indexed bonds to safeguard their wealth.

Here are two bond options to consider:

  • Treasury Inflation-Protected Securities (TIPS): TIPS are a type of U.S. treasury bond that adjusts the value of your investment based on changes to the CPI. With that, these bonds keep pace with inflation.
  • Series I Bonds: An I bond earns a combined interest rate which includes a fixed interest rate and the inflation rate. When you invest in this type of bond, your investment will stay ahead of inflation. But there’s a limit to how many I bonds you can purchase each year.

Invest In Equities

Although there is more risk involved, stock returns often outpace bond returns. With that, it’s possible to beat inflation through stock market investments.

However, the stock market doesn’t come with any guarantees. Instead, there’s risk involved as you build a portfolio. Before diving in, take time to research the appropriate stocks for your unique financial goals.

Build Up Your Emergency Fund

An emergency fund can help you weather any economic storm. When inflation makes it challenging to make ends meet, your emergency fund can provide the buffer you need while you make changes to your spending.

Many experts recommend tucking away 3 – 6 months’ worth of expenses in an emergency fund. Although saving that sum is a challenge, the financial cushion could save the day when inflation pinches your budget.

Refinance When Rates Are Low

When purchasing a home, you don’t have too much control over interest rates. Although your credit score can help you find the best rate on the market, depending on the conditions, that could still be a relatively high rate.

If you get stuck with a higher mortgage rate, keep an eye on the market. When interest rates come back down, you can pursue a refinance. Essentially, a refinance replaces your existing mortgage with a new mortgage and a lower interest rate. If you can jump on refinancing when rates are low, you could save thousands over the life of your loan.

Hold Off On Big Purchases, If You Can

Big purchases can put a strain on any budget. But when inflation is involved, these purchases can be even more expensive. In some cases, you might decide to hold off on a big purchase until the prices settle out.

For example, as of 2022, the demand for new vehicles is vastly outpacing the supply. If you’ve tried to purchase a vehicle in the last two years, you’ve likely noticed a lack of inventory. That’s because the issues in the car supply chain have kept the inventory low.

But the demand for new vehicles has remained steady. With that, prices have spiked upwards. According to Kelley Blue Book, the average price of a new vehicle is $48,043, that’s 12.7% from a year prior. Demand-pull is having a big impact on the auto industry and hurting the wallets of everyone who needs a new vehicle now.

Sometimes a big purchase is unavoidable. But if you can hold off on big purchases, it could pay off in the long run.

The Bottom Line

When inflation sets in, the economy might be in for a bumpy ride as the Federal Reserve raises interest rates to get back to its target inflation rate. But you can take steps to ensure that your household survives and thrives during these tumultuous economic times.

If you have a high interest rate attached to your mortgage, consider refinancing with a lower interest rate today. Ready to lock in lower rates? Start a mortgage application to refinance today.

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Apply online for expert recommendations with real interest rates and payments.

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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.