The Effects Of Inflation: What You Need To Know

The effects of inflation are easy to see – and feel. You’ve likely seen evidence of it in supermarket aisles or at car dealerships. From health care to energy prices – and everything in between – inflation is making daily life a little more expensive for everyone.

But what exactly is inflation? What causes it to surge and sink? And what does it mean for our wallets? Let's explore the answers.

What Is Inflation?

Economists define inflation as a general increase in the prices of goods and services over a period of time, which leads to a general decrease in the purchasing value of a dollar. Loosely translated, inflation is the rate at which prices rise for everyday items. And when inflation goes up, your dollar buys less. While climbing inflation erodes purchasing power – many economists believe inflation is an important component of a healthy economy.

Experts typically measure inflation using the Consumer Price Index (CPI), which tracks price changes for a “basket of goods and services.” In the “basket,” you’ll find price data from 75 urban areas for hundreds of consumer services and items, including food, housing, medical care and clothes. With this information, economists can see how Americans spend their money – and how inflation impacts their spending.

What Is The Current State Of Inflation In The US?

Though the Federal Reserve (The Fed) hasn’t established an official inflation target, experts and policymakers generally consider inflation rates around 2% to be acceptable. Over the last decade, the average inflation rate in the U.S. has hovered around 2.42%. As of May 2023, the rate was almost double that at 4.05%.

According to the Bureau of Labor Statistics, which calculates the CPI and publishes the results every month, in May 2023, the CPI rose 0.1% and rose 0.4% in the previous month. Housing prices were the largest contributor to the higher index numbers, while energy prices fell.

The CPI rose 4% from May 2022 to May 2023. And during the same period, the food index rose by 6.7%.

Why Does Inflation Occur?

So, what causes high inflation? Variations in the supply and demand of different goods and services can ultimately lead to an increase in the costs associated with those goods and services. Other factors can cause inflation to soar, including:

• Policy changes: Fiscal policies such as lowering interest rates, cutting taxes and increasing the money supply can directly impact the rate of inflation.
• A wage-price spiral: This term describes the relationship between rising wages and rising prices. When we make more money, consumer demand for goods and services tends to increase, which can, in turn, lead to higher prices.
• Bottlenecks in the supply chain: When supply constraints and shortages reduce the supply of an item, it can cause inflationary pressure.
• Changes in the cost of materials: Production costs play a key role in determining the prices of consumer goods. When it costs more to produce a product, the product costs more to buy. This phenomenon is known as cost-push inflation.
• Increased demand for items: When there is more demand for an item than there is supply – even if the supply stays the same – prices can skyrocket. According to an analysis by the Federal Reserve Bank Of New York, high consumer demand was behind approximately 60% of U.S. inflation from 2019 to 2022.

Is Economic Inflation Good Or Bad?

Inflation is neither good nor bad. We all know that when inflation rates are high, consumers watch in horror as the value of their money erodes. But some economists believe an economy without inflation is an economy that can’t grow. We’re exploring the positives and negatives of inflation to help you better understand this nuanced economic concept.

Positive Effects Of Inflation

Affordability is a top priority for most consumers. So, it’s not surprising that many see inflation as a negative. But in reality, inflation can have numerous positive effects.

Keeps Deflation Under Control

Inflation helps keep prices relatively stable and prevents deflation, which refers to a general decrease in the prices of consumer goods and services. While rock-bottom prices may seem appealing on the surface, deflation can lead to lower incomes and less consumer spending, which may lead to a recession or full-blown depression.

Encourages Spending And Investing

Let’s say you’ve had items sitting in an online shopping cart for a week and learned that the cost of your items is about to go up. Wouldn’t you feel more inclined to click the “buy now” button sooner than later? More often than not, the answer is “yes!” That reaction supports the idea that a small amount of inflation can lead to upticks in spending and investing despite higher prices.

Lowers Debt Service Costs

High levels of inflation can help reduce the cost of borrowing money over time. For borrowers making debt payments with a relatively low interest rate, an increase in inflation – when paired with an equal increase in their wages – can lead to less of their monthly income going toward debt payments. Homeowners with a fixed-rate mortgage or any fixed-rate won't experience any inflation-related impact on their monthly payments.

Reduces Unemployment

In the short term, higher inflation can reduce unemployment rates and encourage economic growth. Historically, inflation spikes have led businesses to hire more workers to meet increased consumer demand. But these positive effects on the economy diminish when high rates of inflation persist over a long period of time.

Negative Effects Of Inflation

For all the positives associated with inflation, there are downsides to consider as well.

Disproportionately Impacts Low-Income Households

While we are all impacted by spikes in inflation, it’s important to understand the oversized effect of inflation on socioeconomic status. Lower-income households feel the negative effects of inflation sooner and deeper than higher-income households. Low-income and fixed-income consumers tend to have less cushion in their budgets to cover rising costs when inflation rises.

Raises Cost Of Living

Price hikes cause consumers to spend more of their hard-earned cash each month on basic necessities like food and utilities. Spending may not be as painful for consumers with incomes that adjust with inflation, but for consumers with salaries that barely keep up with the rise in the cost of goods and services, this means an increased cost of living across the board.

Causes Higher Interest Rates

Inflation affects more than the cost of goods and services – it also impacts interest rates. The Fed, which is the central bank of the United States, adjusts interest rates to manage inflation. If measurements indicate higher levels of inflation, the Fed responds by raising the benchmark federal funds rate, which, in turn, raises minimum interest rates as well.

This monetary policy change can minimize the opportunity for risky or volatile investments, though rising rates can also make it more challenging for borrowers to afford even the soundest of investments.

Introduces Risk Of Hyperinflation

Hyperinflation is inflation gone wild – and it can collapse economies. While it's seldom a risk in developed countries, they aren’t immune to these extreme increases. Hyperinflation is when inflation reaches 50% every month over several months. It’s typically the result of bad monetary policies and unstable economic policies.

Hurts The Growth Of Stocks And Bonds

Rising inflation can negatively impact the value of bonds. Increasing interest rates lead to decreasing market prices. So, when inflation rises, bond values tend to drop. Similarly, stock market investments typically have a lower rate of return when inflation is high.

The Impact Of Inflation On Real Estate

If you’re in the market to buy a house, you may be wondering how inflation affects mortgage rates. Although inflation doesn’t impact mortgage rates directly, it can play a major, indirect role.

Rising inflation typically leads the Federal Reserve to raise the federal funds rate, which sets off a chain of events that ultimately leads to rising interest rates for fixed-rate and adjustable-rate mortgages. When the federal funds rate is raised, it makes it more expensive for banks and lenders to lend money, and that added expense is passed on to borrowers. Besides mortgage rates, inflation can also directly impact housing prices and inventory.

The Bottom Line On The Effects Of Inflation

Inflation isn’t all good or all bad. A rising rate of inflation at the right time can help stimulate positive economic growth.

If inflation is pushing you to revisit your investments and spending habits, now may be the right time to prioritize saving money, as high-yield savings accounts offer higher interest rates.

If you need help finding cash to set aside, download the Rocket Money℠ app to discover new ways to trim your spending!