Inflation

Why should I care about inflation?

For markets: Inflation directly affects financial markets in a few ways. For one, central banks keep a close eye on the measure, with most targeting a 2% inflation rate (the US Federal Reserve put this target in place in 2012). For example, if inflation is above target, central banks typically hike interest rates and, all else equal, investors tend to sell stocks in response – and vice versa. A second way inflation impacts markets is through influencing spending patterns. Assuming high inflation has led to higher interest rates, making it more expensive to borrow money, spending might slow – knocking the earnings of companies and their stocks by extension.

The bigger picture: When inflation is high, investors may protect their portfolios by buying value stocks over growth ones, inflation-linked bonds, commodities, and real estate.

For you personally: Inflation affects the cost of everyday items and – through central banks’ response to it being too high or low – the interest rates you pay on loans. And while you might already be a diligent saver, inflation will – over time – eat away at the value of your savings. For example, over roughly 25 years, a modest inflation rate of 3% will cut the value of your cash in half. That’s where investing enters the ring, and lots of people begin with a simple goal: to stop their savings from being eroded by inflation.

What causes inflation?

Three key mechanisms contribute to price inflation:

Demand-pull: This is where the demand for goods and services is greater than their supply. It can be down to increased consumer, business, or government spending. For example, suppose a government launches a large infrastructure project. In that case, it’ll increase demand for construction materials and labor. If supply can’t keep pace, the prices for what materials and labor are available will rise until supply and demand are more equal.

Cost-push: This is where production costs increase, and those producing goods and services choose to raise prices to maintain their profit margins. A common cause behind this type of inflation is an increase in the prices of raw materials. For instance, a rise in oil prices can lead to higher transportation and production costs across multiple industries, subsequently increasing final product prices.

Built-in: Also known as wage-price inflation, this type arises from the tendency of businesses to increase wages to match the cost of living increases due to previous inflation. Higher wages can lead to higher production costs, which businesses often pass on to consumers through increased prices, thus creating a feedback loop that perpetuates inflation.

These mechanisms are interlinked, where one type can lead to another, creating a complex inflationary environment in an economy. Understanding these mechanisms helps central bank economists devise strategies to control inflation levels, aiming to balance economic growth and stability.

How is inflation measured?

To measure inflation, economists and statisticians compare the current prices of goods and services to a period in the past to see whether they’ve increased (inflation) or decreased (deflation). The US's most commonly used inflation indexes are the consumer price index (CPI) and the personal consumption expenditures (PCE) price index. Both measures are collated and published by the US government and are calculated differently, providing different perspectives and details on specific market segments and consumption patterns.

Consumer Price Index (CPI)

What it measures: The CPI, released by the US Bureau of Labor Statistics (BLS), measures the average change over time in the prices paid by urban consumers for a basket of consumer goods and services. It is often used to adjust consumers' income payments (like Social Security) for inflation, providing a snapshot of the cost of living. It is one of the most widely used indicators for identifying periods of inflation or deflation.

How it’s calculated: It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Prices are collected for thousands of items in various categories and locations and weighted according to importance.

Personal Consumption Expenditures (PCE)

What it measures: The PCE price index, published by the US Bureau of Economic Analysis, tracks changes in the prices of goods and services consumed by all households and non-profit institutions serving households in the US. It considers a broader range of goods and services than the CPI and is adjusted more frequently for changes in consumer behavior.

How it’s calculated: Unlike the CPI, the PCE index uses data on actual expenditures from the Bureau of Economic Analysis and includes all goods and services consumed by households. PCE is the Federal Reserve’s favored inflation gauge.

Producer Price Index (PPI)

While not a measure of consumer inflation, the producer price index is still worth mentioning. PPI, also produced by the BLS, measures the average change over time in the selling prices received by domestic producers for their output. This index differs from CPI and PCE as it focuses on the whole output of producers in the economy and is often seen as a leading indicator of consumer price changes. Meanwhile, CPI measures prices from the viewpoint of the consumer.

Types of inflation by pace

Creeping inflation occurs when the inflation rate is low and changes slowly, typically defined as a rise of 3% or less per year. This level of inflation is generally considered normal and even healthy for a growing economy, as it encourages consumers to buy now rather than later, knowing that prices will continue to increase moderately. Because of its predictability, creeping inflation usually does not disrupt economic planning and may enhance overall economic productivity by encouraging consumption and investments.

Walking inflation – also known as trotting inflation – is when prices rise by between 3% and 10% annually. This rate of inflation signals a heated economy where demand outstrips supply. It can lead to higher economic output in the short term but poses risks if it accelerates beyond control, potentially requiring central banks to step in and prevent escalation.

Since April 2021, the US economy has seen walking inflation. The inflation rate in the US recorded a 40-year high of 9.1% in June 2022.

US CPI over time. Source BLS.

Galloping inflation is more severe, with price increases ranging from 10% up to 1,000% per year. It indicates an economy in distress, and consumer and investor confidence in the currency is likely eroding as quickly as the currency’s own purchasing power. This kind of inflation can be disastrous if not controlled, leading to a loss of savings and uncertainty in investments. It can necessitate drastic measures from governments and central banks to stabilize the economy.

Hyperinflation represents an even more extreme case of galloping inflation, where prices rise by more than 1,000% per year (or by more than 50% month over month). It usually occurs only under extraordinary conditions, like profound political or economic instability. During hyperinflation, the currency's value essentially collapses, prices can double within days or even hours, and the economic functions reliant on the currency (like buying basic goods, savings, and lending) can disintegrate, leading to a reliance on foreign currencies or barter systems.

Zimbabwe experienced one of the worst cases of hyperinflation in the 21st century, triggered by poor economic policies, such as land reforms that disrupted agriculture, a major income source. By 2008, inflation rates reached an astonishing 79.6 billion percent month-on-month, rendering the Zimbabwean dollar practically useless. This caused severe problems, such as food shortages and a collapse of the healthcare system, forcing millions of Zimbabweans to flee or face starvation.

These inflation types are connected through their intensities: each can escalate into the next if economic conditions deteriorate and corrective measures aren’t implemented effectively.

What happens when inflation is too high?

High inflation can erode purchasing power as each currency unit buys fewer items, like food or energy, than before. That decreases consumers’ disposable incomes, potentially limiting their living standards and reducing their ability to save and invest. High inflation can also lead to increased uncertainty among consumers and businesses, making it harder for them to make long-term financial plans and investment decisions, potentially stalling economic growth.

What’s more, if consumers’ incomes don’t keep up with high inflation, their spending on all but their essentials (and eventually even on essentials) will drop off, hitting economic growth. Businesses, meanwhile, might hold off on their spending plans due to the unpredictability of future costs and profits. That, too, will weigh on short-term economic growth as well as have longer-term effects like lower job creation. In more extreme cases, prolonged high inflation can lead to boom-and-bust cycles, where periods of rapid economic growth are followed by recessions, further destabilizing the economy.

When inflation is too high, central banks increase interest rates. Higher rates discourage people and companies from spending by making borrowing more expensive. And the resultant lower demand for goods and services should keep a lid on price rises, bringing inflation back under control.

What happens when inflation is too low?

Too-low inflation or deflation (prices falling over time) suggests an economy is doing poorly: people aren’t getting pay raises, and there’s not enough demand for goods and services to support higher prices for those things. That may lead to decreased spending over time, as consumers may delay purchases in anticipation of future price drops. That lower spending may push businesses to lower prices further to attract customers, leading to a deflationary spiral. That’d lead to job cuts and hurt economic growth.

When inflation is too low, central banks decrease interest rates. Low interest rates reduce the cost of borrowing and help to boost growth: when loans are cheaper, businesses are more likely to take them out. And those businesses might then use that cash to expand operations, leading to increased business activity and reduced unemployment.

Lower rates also make it cheaper for individuals to spend on credit – so personal consumption (particularly of high-value items like cars and houses) should tick up too. If an economy seems to be faltering, low interest rates can therefore prop it up on two fronts.

What is the difference between inflation, deflation, and disinflation?

Inflation measures the rate at which prices rise over time, and is typically driven by higher consumer demand or higher costs for producers.

Deflation is the opposite: it’s the rate at which prices fall over time. Lower prices would be great on the face of it. But sustained deflation can lead to reduced economic activity as consumers delay purchases, triggering a spiral of falling prices, job cuts, lower wages, and a weak economy.

Disinflation, meanwhile, describes a slowdown in the rate of inflation. In other words, it indicates that prices are still rising but at a slower pace than before. After periods of high inflation, disinflation is often seen as a positive sign, suggesting that inflationary pressures are under control, which can help maintain an economy's stability without the risk of deflation.

Frequently Asked Questions about inflation

Is inflation good or bad?

Inflation isn't inherently good or bad; it depends on context and rate. Moderate inflation is normal in growing economies and can stimulate spending and investment. However, high inflation can erode purchasing power and savings, leading to economic instability. Low or negative inflation (deflation) might seem advantageous but can lead to reduced consumer spending as people wait for prices to drop further, potentially stifling economic growth.

What is the best way to hedge against inflation?

To hedge against inflation, consider investments that help maintain or increase the value of your investments in times of inflation:

• Stocks: Particularly companies with strong “pricing power” that can pass on higher costs to consumers without a loss in demand, like those in the consumer staples or healthcare sectors.
• Real estate: Property values and rents often increase with inflation.
• Inflation-linked bonds: Treasury Inflation-Protected Securities (TIPS) in the US increase their principal and interest payments with changes in CPI.
• Commodities: Including gold or oil, which tend to appreciate when inflation rises.