Inflation is the rate of change in the prices of many goods and services over time. That rate has hit historic highs over the past year: You likely experience the pinch of inflation every time you make a purchase these days, but this headache-inducing phenomenon still may feel unfamiliar to you. After all, inflation in the U.S. economy has generally been low for the
As prices skyrocket, it's worth understanding how inflation works and how to tame it.
What are the main causes of inflation?
Inflation occurs when there's an imbalance of supply and demand for goods and services. Prices tend to rise when total demand exceeds total supply. They tend to drop when the opposite occurs. There are two main types of inflation: demand-pull and cost-push. Traces of both exist in today's inflationary environment.
Prices go up when demand for goods and services rises quickly but producers can't keep up. Demand on such a massive scale can increase when people have more disposable income to spend—such as if they
Demand remains stable, but suppliers face increases in the cost of production that they may pass on to consumers. This includes
In addition, companies may have difficulty accessing raw materials. It's part of why prices for new cars are so high right now: While lots of people still want new vehicles, manufacturers struggle to meet the demand due to a
Is inflation bad?
Inflation itself isn't necessarily a bad thing. The Federal Reserve, which has a dual mandate to promote maximum employment and stable prices, would like to see
That amount of inflation helps keep the economy healthy and acts as a buffer against what's known as deflation should the economy weaken. Deflation is a drop in prices over time, which can lead to a variety of problems, including layoffs.
Two primary measures of inflation
The Consumer Price Index (CPI) is one of the most widely used inflation gauges. The index measures price changes across a sample of day-to-day goods and services purchased by consumers in urban areas. This "basket" of purchases includes food, clothing, shelter, energy, transportation and medical care.
So when the Bureau of Labor Statistics announced that the
Although the CPI generally gains the biggest headlines, another popular measure of inflation is the Bureau of Economic Analysis's Personal Consumption Expenditures Price Index (PCE). This is the index on which the Federal Reserve bases its 2% inflation target.
Like the CPI, the PCE is released monthly and prices a sample of goods and services. The indexes are set up differently, however, and the PCE's inflation figure is often lower than the CPI's. In May 2022, the
How do you solve a problem like inflation?
Expectations play a role in how inflation works. It can worsen not only because of what is happening—like demand outstripping supply—but what consumers and businesses anticipate will happen.
These expectations can lead people to behave in ways that could exacerbate inflation. Rather than buying a car in three months, some people may choose to buy one today, anticipating higher prices if they wait. Or, large numbers of workers may negotiate for higher wages because they expect their daily costs will continue to go up.
There's another reason inflation is so wily: Economists can't always fully grasp market conditions in real time. In March 2022, Fed Chair Jerome Powell acknowledged that "forecasters widely
The Fed has tools to fight inflation
One of the ways the Fed can try to reduce inflation is by raising the federal funds rate. It's the interest rate that banks charge each other for lending or borrowing reserve balances overnight, and it in turn influences other interest rates.
The strategy aims to dampen demand, thereby cooling down the economy. When borrowing money becomes more expensive, individuals are more likely to hold off on buying a home, car or other purchase they expected to finance. Businesses also could decide against taking out loans. On the flip side, a higher interest rate could incentivize people to save more.
The Fed has begun
The Fed will stop reinvesting funds from maturing securities into other securities. This phased approach also could push interest rates higher because, as Bankrate explains, it "effectively
Could raising the cost of borrowing end up hurting the economy? Yes. Manipulating the interest rate is a balancing act—if demand drops too dramatically, the nation could dip into a recession. The
Create your plan of action for handling inflation
Inflation can make it hard to manage many areas of your own financial strategy. It can be quite challenging to create and stick to a day-to-day budget when expenses seem to be constantly rising. Likewise, it's not easy to make decisions about borrowing, short-term investments and
You don't need to work through all the variables alone. A