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How inflation works & what causes it

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Westend61/Getty Images/Westend61

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 past 30 years.

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.

Demand-pull inflation

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 built up savings during the pandemicreceived stimulus checks from the government or scored higher wages as companies fight to retain workers.

Cost-push inflation

Demand remains stable, but suppliers face increases in the cost of production that they may pass on to consumers. This includes rising gas prices that make it more expensive to transport goods as well as higher labor costs.

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 shortage of semiconductor chips.

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 inflation in the U.S. hover around 2%.

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 CPI rose 8.6% from May 2021 to May 2022, it was saying that consumer prices jumped 8.6% during that time period. Notably, that rise was the biggest 12-month increase since December 1981.

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 PCE increased 6.3% from the year before, slightly lower than the CPI's 8.6% climb.

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 underestimated the severity and persistence of supply-side frictions, which, when combined with strong demand, especially for durable goods, produced surprisingly high inflation."

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 hiking the federal funds rate and as well as employing another inflation-fighting tool: reducing the size of its balance sheet. Its holdings grew when it purchased U.S. Treasury securities and mortgage-backed securities during two years of the pandemic to help protect the economy during so much upheaval.

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 reduces the money supply and the availability of credit in the financial system."

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 National Bureau of Economic Research defines this period as "a significant decline in economic activity that is spread across the economy and that lasts more than a few months."

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 long-term retirement planning amid uncertainty about interest rates and the persistence of soaring inflation.

You don't need to work through all the variables alone. A financial advisor can help you create a plan to stretch your income and protect your finances when both inflation and the frustration it creates are high.