What is inflation and why does it matter to investors?

Inflation is the rise in prices of products and services that people use every day. When the cost of basic items like food, electricity, and transportation goes up, individuals and businesses simply can’t buy as much as they could before. Multiply this across millions of transactions and the entire U.S. economy feels the effects. Here’s what you need to know about this closely watched economic indicator.

What is inflation and why does it matter to investors?

What causes inflation?

It might seem surprising, but economists don’t all agree on what causes inflation. There’s a lot of debate around the topic. What they do agree on is that the source of inflation can be classified into two broad categories:  

·      Demand-pull inflation: This essentially means that if more people want to buy something, demand increases and prices go up; or when there’s a limited supply, consumers are willing to pay more.

·      Cost-push inflation: The rising costs of doing business—like increases in the price of raw materials or a higher minimum wage—mean that companies have to pass along price increases to their customers to remain profitable.

Inflation and interest rates: what’s the connection?

Rising prices aren’t necessarily a bad thing: A steady, measured amount of price inflation is normal—it’s considered a sign of a healthy economy.

Too much inflation or unexpected swings in prices can cause real problems, though. This is what happened during the period known as the Great Inflation. From 1965 to 1982, inflation spiked and ebbed on several occasions, eventually reaching an unprecedented high and creating a national crisis. It wasn’t until the U.S. Federal Reserve (Fed)—which is responsible for setting monetary policy and short-term interest rates—raised the federal funds rate1 to its highest point in history that the crisis ended.2

How do interest rates affect inflation? When the Fed makes changes to the federal funds rate—the base interest rate at which banks borrow money and the benchmark for short-term lending—those changes directly influence the cost of debt. When borrowing money is cheap, consumers and business tend to borrow and spend more, which often leads to higher rates of inflation. When debt is expensive, the opposite happens: Consumers and businesses tend to save and invest rather than spend, and inflation rates tend to be more subdued. 

These days, the Fed has an explicit inflation rate that helps inform monetary policy. Since 2012, that target inflation rate has been 2%; currently, inflation is around 1.6%, for context.3 

How the Fed measures inflation

To track trends in inflation and prices, these days the Fed relies on data from the personal consumption expenditures (PCE) index, run by the Bureau of Economic Analysis. The PCE reports monthly prices for items that consumers use on a daily basis. Spending on cars, clothing, healthcare, travel, and other items is systematically tracked. (Food and energy prices are also captured, but not included in what’s known as the core basket, since prices for these items swing widely and can skew the average.) The change in prices for this core basket of goods and services is how the Fed keeps track of where inflation stands.  

Why future rates of inflation matter today

Inflation rates may not matter much day to day, but the longer-term effects can be quite significant. If you have to budget for higher tuition rates when your kids attend college, save more for a down payment on a house, or increase your contribution to retirement savings because these things all cost more down the road, you’ll have to make new choices about how to save and spend today. 

That’s where a financial advisor can help, answering questions you might have around interest rates and inflation, assisting with goal setting, and suggesting new saving or investing strategies that may help counteract the effects of inflation on your wallet.