What Are the Causes of Inflation?

Inflation has numerous causes, but for the most part, they fall into two camps: demand-pull and cost-push. Demand-pull happens when an increase in the demand for goods and services leads producers to raise prices to maximize profits. Cost-push occurs when producers raise prices because their costs have gone up. Over time, inflation can significantly impact your cost of living, and it affects everyone, from ordinary people to businesses and the stock market. As an investor, you may want to seek the guidance of a financial advisor to help you hedge against inflation and protect your investments.

Understanding Inflation

Inflation is an increase in the price level of goods and services throughout a specific time frame. Basically, it means that a dollar today buys less than it used to. It’s usually discussed in terms of a percentage rate. So if inflation is 2%, a carton of eggs that was $3 is now $3.06.

It may not sound like much, but remember that inflation reflects price increases across the economy. So with high inflation, people whose incomes don’t rise in tandem with the cost of living may no longer be able to afford their lifestyles.

For example, consumer prices went up 8.5% over the 12 months ending March 2022. It was the largest 12-month hike since December 1981. So if a carton of eggs was $3, it was then $3.26. As of August 2024, consumer prices were up 2.5% over the previous 12 months.

If the inflation rate breaches 50%, you’ll find yourself in hyperinflation territory. You can expect prices on almost everything to skyrocket. When inflation occurs during a recession, you get stagflation. This can lead to hyper unemployment and extremely low purchasing power. So it’s no surprise that inflation is linked to what’s called the Misery Index, an economic bellwether that measures in part how the average person is faring against inflation.

Measures of Inflation

Inflation can be measured in several ways, each providing a different perspective on price changes in the economy. The following represent the primary metrics used to measure inflation:

Consumer Price Index (CPI): The CPI is one of the most widely recognized inflation indicators. It measures the average change over time in the prices paid by consumers for a basket of goods and services, including items like food, transportation, education and recreation. The CPI is often used as a primary indicator of inflation. However, it doesn’t include savings, investments or spending by foreign visitors.
Producer Price Index (PPI): The PPI measures inflation from the perspective of domestic producers, tracking changes in the selling prices of goods such as fuel, agricultural products, chemicals and metals. Unlike the CPI, which reflects what consumers pay, the PPI focuses on what producers receive. A spike in the PPI can indicate future consumer price increases if producers pass rising costs onto consumers.
GDP Deflator: The GDP deflator, calculated by the U.S. Bureau of Economic Analysis (BEA), reflects price changes for all goods and services produced in the economy. It provides a broad view of inflation that includes data from both the CPI and PPI, capturing the overall price level changes across the entire economy.
Personal Consumption Expenditures (PCE) Price Index: The PCE Price Index measures price changes in consumer goods and services, but unlike the CPI, it includes a wider array of expenditures. This index is based on data from business surveys, which tend to be more comprehensive and reliable than consumer surveys. The Federal Reserve often prefers the PCE as its primary measure of inflation due to its broader scope.

Common Causes of Inflation

Inflation plays an important role in the economy, affecting everyone’s finances. In order to understand its role better, let’s take an in-depth look at the five premier causes of this economic phenomenon.

Growing Economy

In a growing or expanding economy, unemployment drops and wages usually rise. As a result, more people find themselves with more money in their pocket, which they’re willing to spend on luxuries as well as necessities. This higher demand allows suppliers to increase prices, which in turn leads to more jobs, which puts more money in circulation, and round and round it goes.

In this context, inflation is considered a positive thing. Indeed, the Federal Reserve wants there to be inflation, because it’s a sign of a humming economy. But the Fed wants only a little inflation, and aims for a 2% annual core inflation rate. Many economists agree, putting the target annual inflation rate at 2% to 3% as measured by the consumer price index. They consider this a healthy increase as long as it doesn’t drastically outpace the growth of the economy as measured by gross domestic product (GDP).

Because a growing economy can lead to an increase in consumer spending and demand, it’s considered a form of demand-pull inflation.

Expansion of the Money Supply

A shopper looks at a price tag, considering what causes inflation.

An expanded money supply can also drive demand-pull inflation. This happens when the Fed prints money at a rate higher than the growth rate of the economy. With more money in circulation, demand grows and prices go up.

Here’s another way to look at it: Think of an online auction. The more bidders (or the more money pursuing an object), the higher the price goes. Remember, money is essentially worth whatever we believe is valuable enough to trade it for.

Government Regulation

The government can impose new laws or tariffs that make it more expensive for companies to produce goods or import them. They pass on those higher expenses to consumers in the form of increased prices. This results in cost-push inflation.

Managing the National Debt

When the national debt skyrockets, the government has two main options. One is to raise taxes to make its debt payments. If it hikes corporate taxes, companies will likely shift the burden onto consumers through higher prices. This is another scenario of cost-push inflation.

The government’s other option, of course, is to print more money. As explained earlier, this can result in demand-pull inflation. So if the government uses both approaches to tackle the national debt, it may effect both demand-pull and cost-push inflation.

Exchange Rate Changes

When the value of the U.S. dollar dips in relation to foreign currency, it has less purchasing power. In other words, imported products – the majority of consumer goods bought in America – become more expensive to buy. Their cost goes up. The resulting inflation is viewed as the cost-push kind.

Consequences of Inflation

At its worst, inflation can seriously lower the value of the money you’ve invested and saved for retirement. It can also set off a vicious cycle that sparks a recession. With an overall decline of purchasing power, consumers drastically cut back on spending, even on necessities. As a result, businesses cut back on investing and spending, and they lay off workers. Unemployed workers, in turn, spend less than they used to, causing businesses to let even more people go.

However, before that happens, the Fed may choose to combat inflation by bumping up interest rates. This takes money out of circulation, thereby cooling the economy down before it overheats.

It’s important to keep in mind, though, that inflation isn’t necessarily negative. At the target rate of 2% to 3%, it can be the hallmark of a healthy and growing economy.

How to Protect Your Finances From Inflation

High inflation can be challenging for both consumers and businesses, but there are several strategies you can use to help safeguard your finances during inflationary periods:

Lock in Low Fixed Interest Rates: Securing a low, fixed interest rate on loans, such as a 30-year mortgage, protects you from rising inflation. Borrowing at low rates, or refinancing when rates drop, ensures that your monthly payments remain stable even as inflation increases.
Invest in Stocks: Stocks generally perform better than bonds in a high-inflation environment, as companies can pass higher costs to consumers, protecting profits. Consider investing in companies that produce commodities or essential goods, which tend to hold up well during inflation. Bonds, on the other hand, usually lose value as interest rates rise.
Buy Inflation-Protected Securities: Treasury Inflation-Protected Securities (TIPS) and other inflation-linked financial products adjust their value to account for inflation, making them a popular choice. Some life insurance policies and annuities also offer inflation protection through cost-of-living adjustment (COLA) riders.
Save at High Interest Rates: Take advantage of higher interest rates by saving in money market accounts or certificates of deposit (CDs). While these yields may not always outpace inflation, they can help minimize the loss of purchasing power.
Invest in Inflation Hedges: Assets like gold and real estate often rise in value alongside inflation, making them effective hedges. These investments can help preserve wealth as general prices increase.

Bottom Line

Inflation is associated with rising prices across the board. A variety of factors can cause inflation, including government action. Sometimes, even, it’s the government’s attempt to control inflation that can make it worse. But a little inflation is a good thing, proof of an expanding economy.

Tips on Protecting Your Retirement Savings from Inflation

To understand inflation-hedging investments like commodities, real estate and precious metals, you may want to turn to a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Don’t leave inflation’s effect on your savings to hazy guesswork. This inflation calculator will give you a better sense of how much the money you have now will be worth when you retire. You should also consider inflation’s effect on your investment strategy.