Inflation: What It Is & How It's Calculated
Inflation can be problematic for consumers, savers, investors, businesses, and governments. The impact of inflation in the short term can be negative for some investment assets and, in the long run, inflation erodes purchasing power.
Inflation Definition
Inflation is the increase in the prices for goods and services over time. Changes in inflation are generally expressed as a percentage, which also reflects the corresponding decrease in purchasing power of a given currency.
How Does Inflation Work?
When you see a headline or hear a report about inflation, the number that you see or hear is typically an aggregate percentage measure for a certain period of time, such as one year.
Inflation is a function of the economic law of supply and demand. Inflation can be driven by higher consumer demand for goods and services, and the willingness to pay more for them. Inflation can also be caused by a decrease in supply of goods and services when demand remains constant.
An underlying cause of inflation is that the money supply from central banks generally increases over time, which tends to support or increase the demand side of things. Inflation isn't a bad thing; central banks generally pursue policies to maintain a certain level of positive inflation. Deflation, where inflation is negative, is generally unwelcome.
Important: Inflation is a macro-economic measurement that reflects pricing changes on a national economy basis, not on a smaller, micro-economy. Therefore, because the inflation measure is a national average, or an aggregate of price changes for a wide range of good and services, it may impact some consumers, households or regions of a country more than others.
How to Calculate the Inflation Rate
There are several different inflation measures that are calculated, and in the United States these are compiled and reported by the U.S. Bureau of Labor Statistics, or BLS. One of the most reported indicators reported by the media is referred to as the Consumer Price Index for Urban Consumers, or CPI-U, which is commonly referred to as CPI.
The BLS uses a relatively complex method of gathering and calculating the CPI numbers. Put simply, the CPI is a weighted average of price changes, using a combination carefully selected items, such as geographic areas, retail establishments, and a range of goods and services.
The CPI calculation includes goods and services from eight main categories including housing, apparel, food and beverages, transportation, recreation, education and communication, medical care, and other goods and services.
Inflation Rate Formula
The basic way to calculate the inflation rate is to subtract the former price or past date CPI from the current date CPI and divide that result by the past date CPI.
The basic formula to calculate the inflation rate for any period looks like this:
Inflation Rate %= (Current CPI - Former CPI) / Former CPI
Why Does Inflation Occur?
To put it simply, inflation occurs when there are more dollars chasing too few goods. Again, some level of positive inflation is normal and viewed as a good thing. Central banks thus generally increase the money supply over time. In economic terms, there are two main causes of inflation: demand-pull inflation and cost-push inflation.
Demand-Pull Inflation
Demand-pull inflation occurs when the aggregate demand for goods or services increases but the supply remains the same, which results in prices being "pulled up." The causes of demand-pull inflation can come from various economic impact factors. For one example, an increase in government stimulus can increase aggregate demand, which causes prices to rise.
The impact of the Covid-19 pandemic resulted in a record-breaking amount of government stimulus, and raised inflation concerns along with the potential for stagflation, where prices rise but growth remains somewhat flat and unemployment remains somewhat high.
Cost-Push Inflation
Cost-push inflation occurs when there is an increase in production costs and the producing companies respond with an increase in the prices they charge to consumers. In different words, the prices are "pushed up" by the producing companies to cover their increased costs and to prevent a reduction in their profit margins.
Is Inflation Good or Bad?
Inflation itself is not inherently a good thing or a bad thing for consumers, businesses, the economy, or the stock market. What makes inflation good or bad generally depends upon how much inflation a given economy is experiencing.
It's normal for inflation to be positive, meaning that in a healthy economy, wages are increasing, investment assets are appreciating, home values are climbing, and the costs of goods and services, in the aggregate, are rising. This also means that the decline in the purchasing power of cash over time is normal and generally healthy.
When Inflation Is Good
Inflation can be good for:
- Fighting deflation: Falling prices for goods and services, or deflation, can potentially be worse than inflation. This is because, when prices are falling, consumers put off their buying until later, which causes businesses to slow down their production to reduce inventories, which then may cause layoffs and higher rates of unemployment. So, when rising prices return following a deflationary period, inflation is a welcome improvement.
- Consumer confidence: When prices are rising, consumers are comfortable spending their money now, rather than later, when prices may be higher. This confidence in spending helps to boost the economy.
- Higher interest rates for deposit accounts: Higher inflation often accompanies higher interest rates, which is a tool the Federal Reserve uses to fight inflation. This tends to boost interest rates on deposit accounts, such as savings, money markets, and certificates of deposit.
- Paying off long-term fixed-rate debt: Homeowners who were fortunate enough to lock in a low interest rate for their mortgage can benefit from inflation, as their income and home values may increase, while their low-interest debt payments remain fixed.
When Inflation Is Bad
In general, and according to the Federal Reserve, inflation can begin to be problematic for the U.S. economy, when it sustains above 2%. But an inflation rate above this benchmark is not automatically bad. What to look out for are inflationary symptoms that can hurt consumers and the economy.
Here are some of the negative side effects of inflation:
- Declining purchasing power: Rising prices means a reduction in the purchasing power of a given currency. This especially harms people on fixed incomes, such as some retirees, who now have to pay more for their goods and services without a corresponding increase in income.
- Erosion of business and investor confidence: Uncertainty over the future purchasing power of money, plus concerns that businesses will shift focus from production to maximizing profits creates fear in the investment community, placing downside pressure on investment assets.
- Falling prices on long-term fixed debt: Rising inflation means that interest payments on existing bonds are worth less in real money terms. This, often coinciding with increased long-term yields, then pushes down the prices of existing bonds, especially those with longer maturities.
- Currency exchange problems: High inflation can cause wild movements in exchange rates, and the pricing of goods in a specific country. For example, Zimbabwe had a bout of hyperinflation, and saw the value of its currency plummet. Some merchants reset prices (in local currency) higher several times a day. Eventually transactions moved towards pricing in USD, and Zimbabwe stopped printing its essentially worthless currency.
How to Hedge Against Inflation
Rising inflation can do damage to a portfolio of investments. But there are some investment types that do better than others in an inflationary environment. If you want to know how to hedge against inflation, you'll need to learn strategies and investment types that can hold up when prices for goods and services are rising.
There's no magic investment type that is guaranteed to outperform when inflation rears its ugly head. Some of the timeless investment strategies and tactics can work well, but there's often no guarantee.
Tip: Investors should use caution when making decisions based on inflation expectations alone because its effect on the economy, and on the prices for a wide range of investment securities, tends to be cyclical. This means that any gains made during this time could be short lived. In different words, the investments that tend to outperform the broad market averages during inflationary environments may under-perform when inflation normalizes.
Investment Strategies for Inflation
Here are some investment strategies and tactics that can help to protect you against inflation:
- Diversification: Holding a diverse range of asset types and investments can be the best defense against almost any adverse market environment.
- Dollar-cost averaging: Prices for investment securities can be volatile when inflation heats up and headlines about inflationary pressures are prominent. Investors who continue to make regular periodic purchases in their investment accounts and retirement accounts can average their cost lower by continuing to buy as the market falls.
- Bond laddering: Since bond yields are generally rising during inflationary and higher rate environments, bond investors are wise to avoid buying single bonds with long maturities. Instead, they can reduce interest rate risk and increase liquidity by purchasing multiple bonds with varying maturities evenly spaced across several months or several years. Some Exchange-Traded Funds follow laddered-bond strategies.
- Reduce exposure to interest rate sensitive investments: Investments to avoid during inflation generally include long-term bonds and growth stocks. Generally, the longer the maturity for the bond the greater the decline in price when interest rates and inflation are rising. Growth stocks tend to underperform during inflation because it erodes away at their future cash flow potential.
Tip: Mutual funds and ETFs can be smart security types to hold during inflationary periods, or almost any economic environment, because investors can easily gain access to a diversified broad market index, and to certain asset types, such as gold, commodities, and REITs, that would otherwise be inaccessible to everyday investors.
Investment Types That MAY Benefit From Inflation
Here are specific investment types that have potential to outperform the broad market averages during inflation:
- Gold: Since gold is a physical asset, many investors view it as a store of value and as an alternative asset to currency. So, during inflationary periods, investing in gold and gold ETFs can be smart diversification tools.
- Commodities: In the early stages of inflation, prices for some commodities rise, as does the prices of the goods that the commodities are used to produce. Broad-based commodity ETF exposure would be one approach to consider. However, since commodities themselves yield 0%, they may be comparatively unattractive when interest rates rise.
- Real estate: Like commodities, the prices for real estate tend to rise along with inflation. This is partly because the raw materials contained in real estate properties are also rising in price. Real estate investment trusts, or REITs, may also benefit because the rental properties they own maintain their necessity, as well their pricing power for rents during inflation.
- Large-cap value stocks: Since the value objective tends to include industries with pricing power, such as financial services and consumer staples, they can hold up better during inflationary environments, compared to growth stocks.
- Some consumer discretionary stocks: Stocks of companies that offer products and services that consumers continue to demand can perform well during inflation.
- TIPS: Treasury inflation-protected securities are Treasury bonds that are indexed to inflation. The principal value of TIPS rises with inflation, as measured by the Consumer Price Index.
- Short-term bonds: Rising inflation often accompanies rising interest rates. Since there is an inverse relationship between bond prices and yields, longer maturities are more sensitive to interest rates. Bonds with short maturities tend to be more stable than those with longer maturities, and may benefit from reinvestment in new higher-yield securities.
FAQs
Also, known as the current rate of inflation, the annual rate is the average of the preceding 12 months. The all items index, which includes food and energy, rose 8.3% for the 12 months ending April 2022, the largest 12-month increase in 40 years.
Inflation can have a negative effect on stocks because the rising interest rates that accompany inflation increase the borrowing costs for businesses and consumers. Higher interest rates can also make stock dividends less attractive to investors, further pressuring stock prices.
Headline inflation is the Consumer Price Index measure of the total average rise in prices for a wide range of goods and services in a given economy. However, core inflation does not include the volatile food and energy prices.
Not every inflationary environment is the same. With that said, inflation is generally caused by an increase in the demand for goods and services (demand-pull inflation), a decrease in supply of goods and services (cost-push inflation), an increase in the money supply, or some combination of the above. In 2021 and 2022, the U.S. economy experienced a combination of pent-up consumer demand and supply disruptions, both of which were caused by the Covid-19 pandemic. Meanwhile, the Federal Reserve and U.S. Government have been actively trying to stimulate the economy through monetary and fiscal stimulus, which can increase demand-pull inflation.
This article was written by
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