Inflation 101: Meaning and Causes

Economists tell us that inflation hurts savers and people with lower-than-average incomes, so it’s important to keep it under control. For many years now, national central banks around the world have succeeded in keeping inflation down. The last time the United States saw very high inflation was in the 1970s. 

But in early 2020, some economists raised concerns that large-scale stimulus spending by the government and the Federal Reserve—the U.S.’s central bank—could result in inflation rising considerably. Below, I’ll explore more about what inflation means and how it affects people’s everyday lives.

When people talk about inflation, we usually mean consumer price inflation. That inflation rate measures the rise in prices of the things you and I normally include in our shopping baskets. 

The standard measure of consumer price inflation is the Consumer Price Index (CPI), which is maintained by the Bureau of Labor Statistics (BLS). The BLS conducts surveys to find out what people typically include in their weekly shopping, and uses that information to construct a “basket” of goods and services that represents what an average American buys. It then monitors the prices of everything in that basket. 

Of course, prices of different goods change at different rates. It’s entirely possible for the price of, say, gasoline to fall because the price of oil drops, while at the same time the price of bread rises because of a poor wheat crop. So, the BLS calculates the average rate of price change for the whole basket, usually over a year. This is called the annualized CPI inflation rate. The BLS also calculates the average price change over a quarter, which is the quarterly CPI inflation rate. However, the annualized rate is the one usually quoted in the news.

When prices are rising fast it’s hard for wages to keep up. So, high inflation squeezes everyone’s finances, and even people with high incomes can feel the impact. 

Here’s an explanation of how this works that really happened to me. Back in the 1970s, when I was a teenager, my parents paid me an allowance. This was supposed to pay for candy, clothes, and socializing with my friends. To start with, it was generous. But by December 1974, prices were rising at over 12% a year—and my allowance stayed the same. So, as time went on, my finances were squeezed; I had to shop and socialize less. And my parents couldn’t raise my allowance because they were being similarly squeezed—my father’s salary wasn’t rising anywhere near that 12% inflation rate. 

Not everyone is affected by inflation. Back in the 1970s, trade unions were able to persuade employers to raise their workers’ wages in line with inflation. And today, retirees’ incomes may rise in line with the CPI inflation rate. But for people whose income growth doesn’t keep up with the pace of inflation, high inflation means they can buy less and less. And for people saving for a rainy day or for retirement, inflation erodes the value of their savings.

The Federal Reserve ended the high inflation of the 1970s by raising interest rates to unprecedented levels. In December 1980, the prime rate on which many consumer loans are based rose to 21.5%, the highest ever recorded.² As inflation fell, the Fed gradually reduced interest rates. Now, it keeps inflation low and stable by continually monitoring and adjusting interest rates. 

If inflation slips too low, the Fed cuts interest rates. This means money is less expensive to borrow, which encourages people to buy more stuff, and that typically causes prices to rise. If inflation starts rising too far, the Fed raises interest rates, making money more expensive to borrow, and forcing people to cut back spending. When people reduce their spending, businesses often cut prices to maintain sales. This brings inflation back down. 

Why doesn’t the Fed keep inflation at zero, or even allow prices to fall? Well, when the economy is growing, prices are more likely to rise than fall. If prices aren’t rising, that can mean that the economy is slowing down, stagnating, or even going into recession. So the Fed targets an inflation rate of 2% per year. 

Ever since the financial crisis of 2008, consumer price inflation has tended to be below the Fed’s 2% target,³ so it has kept interest rates low. But if inflation were to start rising because of stimulus spending, then the Fed might raise interest rates sharply. Some of the ways raising interest rates can squeeze your budget include:

• More expensive new mortgages and loans
• Higher interest payments on existing loans that have variable interest rates, such as adjustable-rate mortgages
• Higher rents, since some landlords might pass on their higher interest costs to their tenants
• And for some people it could mean job loss, since businesses that lose sales and face higher interest costs may have to lay off staff 

But when inflation falls back to target, the Fed can reduce interest rates, giving people more money to spend and enabling businesses to start hiring again.