Inflation impact: Rising prices project strength, but too much is painful

These days, you can’t tune into TV or social media without hearing about inflation. But what is inflation, why does it happen, how is it measured, and are rising prices good or bad? Alarm bells ring if prices rise too quickly, but the opposite—deflation, or falling prices—is arguably worse. Economists and policy makers tend to like the Goldilocks level—one that’s not too hot or cold.

Of course, it doesn’t feel pleasant when your morning cappuccino goes up 25 cents or the landlord hikes your rent. But mild inflation can signal a healthy economy, reflecting both firm demand and growing wealth. You don’t generally see much inflation during recessions.

Paying more for your coffee or rent is one inflation definition. But inflation also refers to overall increases in prices and the cost of living. Governments measure the inflation rate by putting together a basket of common goods and services and calculating how much they’d cost each month.

Producer inflation measures wholesale prices, meaning prices paid by businesses that purchase large volumes of product. Another type is wage inflation, which may sound good for your paycheck, but can spell economic trouble if it gets out of hand.

Inflation definition

Why prices rise

Inflation is a natural and healthy part of a growing economy, provided it stays under control and workers’ salaries don’t lag behind the general rise in prices. Prices rise as populations grow, economies get richer, demand increases, and commodities get scarcer and more expensive. Companies hike prices to meet rising demand, or to pay higher wages and buy more expensive raw materials.

Causes of inflation

When governments inject money into the economy, it can reduce the value of the currency relative to what it can buy, prompting producers to demand more cash for the goods they make and sell.

Another common cause of inflation is a shortage of raw materials, which can be caused by heavy demand (lumber prices exploded after the start of the global pandemic) or supply problems (oil hit near-record highs in 2022 when Russia invaded Ukraine and multiple nations cut off most Russian oil imports).

Oil often gets blamed for inflationary bumps because, like your coffee, everything runs on it. You need oil to go places; companies need it to make and ship their products. When pricey oil raises shipping costs for businesses, that often gets passed along to customers in the form of higher price tags for all sorts of goods. That’s inflation causing inflation in a vicious cycle.

How inflation is measured

Headline vs. core CPI and PPI

The government tracks U.S. inflation and provides monthly updates through the Consumer Price Index (CPI) and Producer Price Index (PPI) reports. The first one monitors prices paid by consumers, the second tracks wholesale prices.

CPI and PPI are measured in two ways:

• Headline CPI and PPI. The total inflation of the basket of goods and services tracked by the U.S. government. The basket can change slightly over time.
• Core CPI and PPI. The inflation rate excluding food and energy, which are prone to sharp price swings. Leaving them out helps economists track more stable price trends—and avoids potentially counting energy-driven price increases twice.

The lag between wholesale and consumer prices

Sometimes PPI and CPI rise at different rates. When producer prices rise, companies don’t always immediately pass along their higher costs to consumers, fearing loss of demand.

In a strong economy, however, many companies eventually do hike prices if they believe consumers can afford to pay more. Companies that pay higher wholesale costs and don’t raise customer prices risk a decline in profit margins. That’s why a rise in PPI is often followed by a rise in CPI as companies accept the inevitable and ask their customers to help foot the bill for pricier shipping or raw materials.

Why inflation can be helpful

For about a decade leading up to 2020, the Federal Reserve maintained a 2% target rate of inflation. Why not zero? Because inflation can drive economic growth in several ways:

• As prices rise consistently, workers are more inclined to invest and spend their money, hoping to outpace inflation.
• Consumer spending gives companies more resources to innovate, expand, and hire.
• Business investment and hiring stimulate economic growth.
• A growing economy creates more competition for top workers, prompting employers to raise wages.
• Higher wages and business profits result in more tax revenue, allowing the government to spend more and fueling even more growth.

Inflation’s impact on consumers

Just the thought of inflation can get consumers to buy. Say you’ve spent several years saving $5,000 for a down payment on a new car, and you know car prices have been rising 5% each year. Rather than wait and risk paying more, you decide to buy the car now.

If prices were flat or falling, you might hold off on making a purchase. But the prospect of rising prices can motivate consumers to spend sooner, which helps keep money circulating. That spending, in turn, supports businesses and wages throughout the economy.

That’s why economists often say that one person’s expenditure is another’s income.

Now envision this happening every day across the country among millions of consumers and businesses. Consumer spending accounts for about 70% of U.S. gross domestic product (GDP), and can be a major force to stimulate economic growth.

How governments respond to inflation

Fiscal tools to influence inflation

To help fuel or cool inflation, governments may use fiscal policy tools such as increased spending, tax cuts, or stimulus checks. These actions inject large sums of money into the economy during slowdowns, encouraging consumers to spend and companies to invest.

The Fed’s role in inflation control

• The Fed funds rate target. Fed funds are balances held at Federal Reserve banks. The market determines that rate, but it’s influenced by the Fed funds target rate that the Federal Open Market Committee (FOMC) of the Federal Reserve sets eight times a year.
• The Fed’s balance sheet. When necessary, the Fed can increase or decrease the number of assets on its books by buying and selling securities on the open market. If you’ve heard the term “quantitative easing,” or its opposite, “quantitative tightening,” that’s Fed-speak for balance sheet expansion and contraction.

When the economy slows, the central bank can reduce the Fed funds rate and/or buy fixed-income securities (Treasury bonds and mortgage-backed securities, for example) to make borrowing easier, inspiring businesses to invest and consumers to buy cars and homes.

If inflation runs hot, it can raise rates and/or decrease the size of its balance sheet by selling securities. Higher rates make mortgages and car loans more expensive, reducing demand and slowing the flow of money through the economy. Over time, that can ease inflation.

The bottom line

Both now and historically, the U.S. inflation rate has been a burning political and economic issue. In the 1970s, Washington even launched an effort called Whip Inflation Now (WIN), with its own campaign buttons. The Fed eventually helped whip that historic inflation by jacking up interest rates to all-time highs above 15%, but not without tons of consumer pain through two back-to-back recessions in the early 1980s.

Fear of Fed tightening tends to hurt stocks, and falling stock prices can make investors and companies nervous and less likely to spend, slowing the economy. That’s another reason why a little inflation is good, but a lot hurts. Deflation also hurts, as seen during the Great Depression. What’s the Goldilocks level? Economists differ, but that 2% rate continues to be the Fed’s target.

References

• Consumer Price Index, 1913–Present | minneapolisfed.org
• Shares of Gross Domestic Product: Personal Consumption Expenditures | fred.stlouisfed.gov
• Inflation: Prices on the Rise | imf.org
• Fed’s New Inflation Targeting Policy Seeks to Maintain Well-Anchored Expectations | dallasfed.org