Inflation is the overall rise in the prices of goods and services over time. The annual inflation rate in the United States averaged 3.27% between 1914 and 2022. As such, moderate inflation has been a fact of life and the natural economic state for more than a century.
This makes it important to distinguish between the inherent effects of inflation at any rate and those that only come into play during periods when inflation runs unusually high. We'll do that below by identifying inflation's most important effects on consumers, investors, and the economy.
Key Takeaways
- Inflation is the sustained and broad rise in the prices of goods and services over time, which erodes purchasing power.
- Inflation is generally caused by an imbalance in supply and demand, supply shocks, and inflation expectations.
- A small but positive inflation rate is economically useful, while high inflation tends to feed on itself and impair the economy's long-term performance.
- Real estate, energy commodities, and value stocks have historically outperformed during periods of high or rising inflation.
- Bonds and expensive growth stocks tend to lag as inflation lowers the present value of their future cash flows to investors.
What Causes Inflation?
Inflation is the rise in prices of goods and services over a certain period of time. When prices rise, consumers lose purchasing power, which means the power of a single unit of currency doesn't go as far as it did before. A little inflation isn't much cause for concern but it can be when prices rise too quickly. But what causes this increase?
Some of the most common factors that lead to inflation include:
- An imbalance in supply and demand. Inflation tends to increase when consumer demand for goods and services increases when supplies are limited at desirable price levels.
- The disruption in supplies or supply shocks can trigger inflation. For instance, global energy prices jumped following Russia's invasion of Ukraine. Russia cut off global energy supplies and tightened the market in response to sanctions placed by the international community. This drop in energy supplies caused prices to increase.
- The expectations of inflation. When people expect prices to rise, they often demand higher wages in order to prepare for future price increases. Producers and businesses tend to respond by raising prices, which causes inflation to rise.
Now let's take a look at some of the major impacts inflation has on the economy.
1. Inflation Erodes Purchasing Power
This is inflation's primary and most pervasive effect. An overall rise in prices over time reduces the purchasing power of consumers since a fixed amount of money will afford progressively less consumption.
Consumers lose purchasing power regardless of what the inflation rate is—whether it's 2% or 4%. This just means that they lose it twice as fast at the higher rate. Compounding ensures that the overall price level increases more than twice as much over the long run if long-run inflation were to double.
Inflation measures the rise in prices over time for a basket of goods and services representative of overall consumer spending. The Consumer Price Index (CPI) is the best-known inflation indicator, while the Federal Reserve focuses on the PCE Price Index in its inflation targeting.
2. Inflation Disproportionately Impacts Lower-Income Consumers
Lower-income consumers tend to spend a higher proportion of their income on necessities than those with higher incomes. This means they have less of a cushion against the loss of purchasing power inherent in inflation.
Policymakers and financial market participants often focus on core inflation. This measurement of inflation excludes the prices of food and energy because they tend to be more volatile and less reflective of the longer-term inflation trends. But earners with lower income spend a relatively large proportion of their weekly or monthly household budgets on food and energy—commodities that are hard to substitute or go without when prices spike.
The poor are also less likely to own assets like real estate, which has traditionally served as an inflation hedge.
On the other hand, recipients of Social Security benefits and other federal transfer payments receive inflation protection in the form of cost of living adjustments (COLA) based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which is an index of consumer prices for hourly wage earners and clerical workers.
3. Inflation Keeps Deflation at Bay
The Fed's target inflation rate is set at 2% over the long run. This allows it to meet its mandates for stable prices and maximum employment. It focuses on modest inflation rather than steady prices because a slightly positive inflation rate greases the wheels of commerce, provides a margin of error in the event inflation is overestimated, and deters deflation. The overall decline in prices can be much more destabilizing than comparable inflation.
Lenders can charge interest to offset the inflation likely to devalue repayments. It also helps borrowers service their debts by allowing them to make future repayments with inflated currency. On the other hand, deflation makes it more expensive to service debt in real terms, since incomes would be likely to decline alongside prices.
One reason modest inflation (rather than deflation) is the norm is that wages are sticky to the downside. Workers tend to resist attempts to cut their wages during an economic downturn, with layoffs the likeliest alternative for businesses facing a downturn in demand. A positive inflation rate allows a wage freeze to serve as a cut in labor costs in real terms.
The benefits of inflation are only insurance against deflation until price hikes exceed the customary and expected rate because inflation can also spiral out of control if high enough.
Because deflation represents a departure from the norm, it's also more likely to trigger expectations for additional deflation, causing further spending and income declines and ultimately widespread loan defaults that can set off a banking crisis.
4. Inflation Feeds on Itself When It's High
A little inflation can signal a healthy economy. As such, it's not something that's likely to cause inflation expectations to rise. If inflation was 2% last year and is 2% this year, it's mostly background noise. Businesses, workers, and consumers would likely expect inflation to remain at 2% next year in that scenario.
But expectations of future inflation will begin to rise accordingly when the inflation rate accelerates sharply and stays high. As those expectations rise, workers start demanding larger wage increases and employers pass those costs on by raising prices on output, setting off a wage-price spiral.
In the worst-case scenario, a bungled policy response to high inflation can end in hyperinflation. But there's no need to count the cost of soaring inflation expectations in wheelbarrow loads of Zimbabwe dollar notes denominated in trillions or in the Weimar Republic's worthless marks from Germany's five years of hyperinflation after World War I. In the U.S., rising inflation expectations during the 1970s lifted annual inflation above 13% by 1980 and the federal funds rate to more than 20% by 1981, while unemployment topped 10% as late as mid-1983 following the ensuing recessions.
Inflation in Weimar Germany
By December 1923, an index of the cost of living in Germany increased to a level of more than 1.5 trillion times its pre-WWI measure.
5. Inflation Raises Interest Rates
As the examples above suggest, governments and central banks have a powerful incentive to keep inflation in check. The approach has been to manage inflation using monetary policy over the past century. When inflation threatens to exceed a central bank's target (typically 2% in developed economies and 3% to 4% in emerging ones), policymakers can raise the minimum interest rate, driving borrowing costs higher across the economy by constraining the money supply.
As a result, inflation and interest rates tend to move in the same direction. By raising interest rates as inflation rises, central banks can dampen the economy's animal spirits or risk appetite, and the attendant price pressures. The expected monthly payments on that boat or that corporate bond issue for a new expansion project suddenly seem a bit high. Meanwhile, the risk-free rate of return available for newly issued Treasury bonds will tend to rise, rewarding savings.
6. Inflation Lowers Debt Service Costs
While new borrowers are likely to face higher interest rates when inflation rises, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation.
Say you borrow $1,000 at a 5% annual rate of interest. If annual inflation subsequently rises to 10%, the annual decline in your inflation-adjusted loan balance will outweigh your interest costs.
Note that this doesn't apply to adjustable-rate mortgages (ARMs), credit card balances, or home equity lines of credit (HELOCs), which typically allow lenders to raise their interest rates to keep pace with inflation and Fed rate hikes.
7. Inflation Lifts Growth & Employment in the Short Term
Higher inflation can lead to faster economic growth in the short term. While the 1970s are recalled as a decade of stagflation, U.S. real gross domestic product (GDP) increased 3.2% annually on average between 1970 and 1979, well above the economy's average growth rate since.
Elevated inflation discourages saving since it erodes the purchasing power of the savings over time. That prospect can encourage consumers to spend and businesses to invest.
As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship. For a time at least, higher inflation can spur demand while lowering inflation-adjusted labor costs, fueling job gains.
Eventually, though, the bill for persistently high inflation must come due in the form of a painful downturn that resets expectations, or else chronic economic underperformance.
8. Inflation Can Cause Painful Recessions
The trouble with the trade-off between inflation and unemployment is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s.
To regain lost credibility and convince everyone again it would control inflation, the Fed was subsequently forced to raise interest rates much higher and keep them high for a longer period of time. That, in turn, caused unemployment to soar, and to stay high for longer than would likely have been the case had the Fed not allowed inflation to spiral so high.
9. Inflation Hurts Bonds & Growth Stocks
Bonds are generally considered to be low-risk investments that provide regular interest income at a fixed rate. Inflation (especially high inflation) impairs the value of bonds by lowering the present value of that income.
As interest rates increase in response to rising or elevated inflation, so does the yield on newly issued bonds. The market price of bonds issued previously at a lower yield then drops proportionally, since bond prices are the inverse of bond yields. Investors with Treasury bonds are still in line for the expected coupon payments, followed by principal repayment at maturity. But those who sell their bonds before maturity will receive less as a result of the increased market yields.
There is less of a consensus about whether high inflation hurts or helps stocks overall. Conclusions depend on the definition of high inflation and whether the historical record cited includes the 1970s, a lost decade for U.S. stocks amid stagflation.
Growth stocks, which tend to be more expensive, are notoriously allergic to inflation. Inflation discounts the present value of their future cash flows more heavily, just as it does for high-duration bonds. Technology and consumer stocks have lagged during past episodes of high or rising inflation.
10. Inflation Boosts Real Estate, Energy, & Value Stocks
Real estate has historically served as a hedge against inflation since landlords can protect themselves by raising rents even as inflation erodes the real cost of fixed-rate mortgages.
Rising commodity prices can cause inflation to accelerate. Once it does, commodities can change when growth slows. This is particularly true of energy commodities that tend to continue to outperform.
Unsurprisingly, energy equities, real estate investment trusts (REITs), and value stocks have historically outperformed during episodes of high or rising inflation.
Areas Impacted
Inflation can have a positive impact on the economy. As noted above, a little inflation can be a good thing for the economy. When prices rise at a moderate rate, people continue to spend rather than save their cash. Most consumers open up their wallets even when there's a slight increase in prices because they often expect things to get more expensive in the future.
But savers will take a hit as inflation continues to rise. For instance:
- You'll have to increase the amount of money you save for retirement. That's because the target amount you set to match your current lifestyle won't be enough when it comes time to leave the workforce. Put simply, you won't be able to afford to support yourself in retirement if you don't adjust how much you're saving based on inflation.
- The value of certain fixed-income investments drops. For example, the rate of return on government-issued securities drops as inflation increases. And when returns drop, more people may decide to sell them, which decreases their value.
- The value of the national debt rises because the amount of interest owed on that debt increases. When this happens, governments may be forced to raise taxes or cut down on spending.
One thing to keep in mind is that not every asset's value moves in the same direction because of inflation. So just because one rises, the other may drop. For instance, mortgage rates may rise but the value of your home may drop.
Who Benefits and Who Doesn't?
As with any other economic phenomenon, inflation comes with both winners and losers. Let's take a look at who gains from inflation and who doesn't.
Who It Benefits
Inflation can be a boon for certain borrowers. Consider mortgagors who have fixed-rate loans on their homes. If you have a rate locked in at 5% and inflation causes interest rates to rise, you won't be affected. That can't be said about your neighbor who may have an ARM that changes based on market rates.
You're probably going to be in luck if you're in the market for a new home. That's because higher prices (and, therefore, higher interest rates) often knock out the competition, boosting the amount of inventory available. So if you can afford it, you're likely going to be able to get the pick of the lot.
Who It Doesn't
Since inflation reduces purchasing power, consumers represent the primary group who stand to lose when prices rise. That's because their money doesn't go nearly as far and allows them a limited number of goods and services they can purchase. Most consumers tend to think twice about buying a big-ticket item, such as a new appliance or a new car when inflation is high.
Home buyers may also feel the pinch during these times. That's because higher prices mean higher interest rates, which makes borrowing more expensive.
People who are on a fixed income are also negatively affected by inflation. Consider retirees who receive Social Security. Although they may receive COLA increases in their benefits, it may not be enough to sustain the same standard of living they're used to when prices increase to certain levels.
What Is Inflation's Primary Effect?
Inflation is the rise in prices of goods and services. It causes the purchasing power of a currency to decline, making a representative basket of goods and services increasingly more expensive.
How Can Inflation Benefit Homeowners?
Homeowners with fixed-rate mortgages benefit from inflation because is discounts the present value of their future mortgage payments. As housing prices rise as a result of inflation, home equity increases. Finally, homeowners who rent out their homes can increase rents with inflation.
What Is Deflation?
Deflation is a sustained period of broadly declining prices. Deflation is often the result of a severe economic contraction that causes consumers and businesses to curtail spending and investing. Deflation is destabilizing because it makes it harder to service debts.
The Bottom Line
Inflation can be a blessing and a curse, depending on how you look at it. On the one hand, governments and central banks plan for manageable price increases by setting inflationary targets and consumers respond by spending as prices tend to increase at a nominal rate. But that changes when inflation overheats. It can diminish the purchasing power of consumers. When inflation runs rampant, governments generally raise interest rates, reduce the amount of money banks must have on reserve, and cut back on the money supply.
