What Causes Inflation To Happen?

Inflation is the increase in the prices of goods and services over time. It means that, on average, you'll need more money to buy the same things you could purchase for less in the past. The Consumer Price Index (CPI) is an economic metric that tracks the rate of inflation over time by measuring the price of various goods and services.

Inflation has been especially high in 2021 and 2022, reaching 7%. Recent high inflation rates are prompting many people to wonder why and how they should respond. Read on to learn what drives inflation, how it may affect your personal finances, and how to manage the impact it has on your finances.

What Are The Main Causes Of Inflation?

According to economists, there are several primary causes and types of inflation that impact economies across the globe. The U.S. Federal Reserve, also known as the Fed, has a target yearly inflation rate of 2%, but the average annual rate from 1960 to 2022 averaged 3.8% in the U.S. Higher inflation rates in 2021 and 2022 are the result of various factors that relate to the supply and demand of goods and services.

1. High Production Costs

Cost-push inflation is a type of inflation commonly caused by an increase in production costs. This occurs when the cost of producing goods and services rises due to factors like increased labor wages and higher prices for raw materials. When these production costs go up, businesses often pass these added expenses on to consumers by raising prices for their products or services, which can spur inflation.

One common example of cost-push inflation is seen in the energy sector. When oil or natural gas prices increase due to geopolitical tensions, it raises production costs for a wide range of goods and services. Higher energy costs boost operating expenses for a variety of businesses. As a result, companies often increase prices to maintain their profit margins, causing inflation. 

2. Supply Disruptions

Another common cause of cost-push inflation is that unexpected events, like natural disasters or geopolitical tension, disrupt the supply of critical products and services. These supply disruptions cause prices to rise because demand is high, yet supply is low.

An example is the global semiconductor chip shortage recently that impacted the auto industry and financial markets because chips are a critical component in modern cars. Increased demand for chips combined with supply chain issues from the pandemic created a scarcity of chips in 2021.

The shortage forced many auto manufacturers to reduce or even temporarily halt production, leading to lower car inventories and late deliveries. Ultimately, the chip shortage caused both new and used vehicle prices to rise due to decreased supply from manufacturing plants, contributing to high inflation rates in 2021 and 2022.

How To Reduce Cost-Push Inflation

High inflation rates can hurt the economy, so many policymakers strive to keep inflation rates under control. To combat cost-push inflation, governments may take steps to reduce production costs, such as promoting competition, streamlining regulations, and investing in technology to enhance productivity. For example, the CHIPS Act of 2022 was designed to boost domestic chip manufacturing capacity and national security by investing $52 billion.

Additionally, reducing the supply of money can help curb inflation. The Fed can increase interest rates to help decrease inflation. Higher interest rates slow the circulation of money, reducing demand for products and services. However, raising interest rates too much can hinder the economy, so it is a balancing act. 

3. An Increase In Consumer Demand

Demand-pull inflation happens when there is a surge in consumer demand for goods and services, which exceeds the capacity to produce them. This type of inflation typically occurs during periods of strong economic growth and low unemployment because money is circulating. As consumers compete for the limited supply of products and services, businesses often raise their prices to benefit from higher demand, leading to an overall increase in prices.

For instance, if there is a housing market boom, demand for homes is higher than supply. More people are wanting to buy homes than the supply of available properties. Home shoppers can even get into bidding wars, trying to outbid others by offering more than the asking price for a property. This increase in demand can impact the affordability of housing in that area by causing prices to soar.

4. Excessive Money In Circulation

During an economic crisis or when governments need to fund large-scale projects, they may resort to printing a lot of money. While this can provide a short-term financial boost and stimulate economic activity, it can also trigger demand-pull inflation.

When governments print a lot of money, it increases the supply in circulation without a corresponding increase in the supply of goods and services. Therefore, excessive money in circulation can spur demand and is another cause of inflation because too much money is available to spend on too few goods and services. When the supply of money grows faster than the economy's productive capacity, it creates a surplus, which drives up inflation rates because shoppers are willing to pay more.

How To Reduce Demand-Pull Inflation

Some countries have experienced such rampant inflation that their currency has become almost worthless. However, there are several strategies central banks and governments can employ to reduce demand-pull inflation. These approaches often focus on decreasing consumer demand to help lower the CPI.

First, they can use monetary policy tools like increasing interest rates to reduce consumer borrowing, thus cooling down spending and demand. For example, if mortgage interest rates are higher, fewer people will buy new homes because high interest rates increase their monthly mortgage payments, making them less affordable.

Politicians can enact policies that limit spending, such as reducing government expenditures or increasing taxes. Reducing spending lowers demand, which eases inflation. Also, policymakers can take action to promote productivity and expand production capacity to help meet growing product demand without triggering inflation. Higher productivity increases the supply of goods, which can lower high inflation rates.

4. A Rise In Wages And The Price Of Goods

Built-in inflation, or wage-price inflation, occurs when workers demand higher wages to keep pace with rising prices. It typically happens when people expect a certain level of inflation and negotiate higher wages.

Workers then have more disposable income because of that raise, so they can spend more. Also, businesses boost their prices to cover the increased labor costs. This scenario creates a self-reinforcing inflation cycle as both wages and prices continuously increase, potentially leading to a wage-price spiral. 

For example, if workers expect an annual inflation rate of 5%, they may demand a 5% wage increase from their employers. To cover the higher operating costs, businesses raise the prices of their products or services. This cycle can cause sustained inflation.

How To Reduce Built-In Inflation

Many of the actions to slow built-in inflation are similar to the approaches of minimizing other types of inflation. Politicians can implement prudent monetary policies, such as raising interest rates. Additionally, governments can promote transparency and fiscal responsibility to manage inflation expectations and avoid contributing to wage-price spirals.

What Are The Effects Of Inflation?

Most economists consider high inflation harmful to personal finances for various reasons, although it can have some benefits. 

• Consumers lose purchasing power. Inflation erodes the value of money over time, so you can buy less with the same amount of money. You will lose purchasing power if your income or savings don’t increase proportionately.
• Your money is worth less in real terms, making it harder to afford the same goods and services. A loss in purchasing power can decrease economic growth because people can buy less.
• Interest rates increase. Central banks often raise interest rates to combat high inflation rates. However, interest rate hikes make borrowing more expensive, affecting mortgages, loans, and credit card payments.
• Unfortunately, this can strain personal finances because you may owe more interest, or you may delay buying a new car or home to wait for interest rates to decrease. However, if you took out a fixed-rate loan when interest rates were low, they will remain the same throughout the life of the loan.
• The cost of living rises. Inflation directly impacts living expenses by increasing rent, grocery prices, and utility costs. When prices go up, it takes a larger portion of your income to cover basic necessities, leaving less for savings or discretionary spending.
• Thus, inflation can really impact people with low-income individuals because a larger percentage of their income usually goes to essential goods and services. Likewise, people on fixed incomes, like retirees, can be really impacted by inflation because their income may remain constant despite inflation.
• Financial planning becomes challenging. Inflation can make financial planning difficult because of uncertainty about future prices. Inflation makes it harder to predict how much money you'll need for everyday expenses, to know what investments will have the best returns, or when interest rates on loans will decrease.
• Eroding the value of some types of savings. If your savings aren't growing at a rate equal to or higher than the inflation rate, the real value of your savings effectively decreases. This can make it more difficult to reach future financial goals, like buying a home or retiring comfortably.

Are There Benefits Of Inflation?

The effects of inflation vary widely depending on whether it is moderate and controlled inflation or rampant inflation. In particular, moderate inflation can have some advantages, like:          

• Encouraging spending: Inflation can motivate some consumers to spend and invest rather than hoard cash. When people expect prices to rise, they are more inclined to put their money to work, which can stimulate economic growth.
• Debt relief: Inflation can decrease the real value of your debt. If you have a fixed-rate loan, the amount you owe remains the same. But, because inflation erodes the value of money, it effectively reduces the burden of the debt in real terms. This can benefit borrowers.
• May foster investment: Moderate inflation can incentivize businesses to invest in expanding production capacity and new ventures. It can make it more profitable for companies to invest in research and development, job creation, and technological advancements.

However, excessively high or unpredictable inflation rates can have numerous negative consequences, such as reduced purchasing power, economic instability, and uncertainty. Therefore, central banks aim to strike a balance by targeting moderate and stable inflation rates, while seeking to avoid deflation.

How To Minimize The Impacts Of Inflation On Personal Finances

There are a variety of steps you can take to reduce the effects of moderate or high inflation on your personal finances.

• Budget wisely by prioritizing essential expenses over discretionary spending.
• Consider investments that historically perform well during times of high inflation, like real estate, commodities, and inflation-indexed securities. Conversely, investments with fixed returns, such as bonds, can be less desirable when inflation rates are high.
• Diversify your investment portfolio and invest in a variety of asset classes and sectors. Diversification can help reduce overall risk and increase returns.
• Explore fixed-rate loans to lock in interest rates and avoid future increases in borrowing costs.
• Continuously seek to improve your job skills and further your education to enhance job security and increase your earning potential. This can allow your wage increases to outpace inflation.
• Minimize your debt to decrease interest payments. Loans can be especially burdensome when interest rates are high because interest payments are also high.

The Bottom Line

Inflation is the gradual increase in the prices of goods and services over time, reducing the purchasing power of money. Although some inflation is helpful for the economy, high inflation rates can negatively affect your finances, especially if your income doesn’t increase accordingly. Price increases often mean that shoppers can’t afford to buy as much. 

During times of high inflation, it's critical to budget wisely. The Rocket Money℠ app can help you stay on top of your finances by helping you track your spending and identify ways to lower your bills. Download the Rocket Money app today to get started.