What is inflation?

We’ve all heard stories from our parents and grandparents about what things used to cost. In the 1950s, you could see a movie in the movie theatre for around 50 cents. These days, a ticket is more like $11.¹ Sixty years ago, you could get a gallon of milk for 49 cents. Today it’s more like $4.² Milk didn’t suddenly become more expensive to make; the price today reflects the decrease in the value of a dollar over time. That’s inflation. 

Typically, low inflation is a sign of a healthy economy as it can encourage investing and growth, and keep interest rates low. Economists generally agree that a stable economy requires a stable level of inflation. 

But what actually causes inflation? The answer usually falls into one of three categories.

Demand-pull inflation

Demand-pull inflation is a result of the increase in aggregate demand for goods and services. In other words, Nike can charge more for a pair of sneakers because people really want them. Supply and demand are very influential in pricing. 

Demand-pull inflation can also stem from a growing economy, increased government spending, or even economic growth overseas.

Cost-push inflation

Just the opposite, cost-push inflation results from a decrease in the aggregate supply of goods and services, related to an increase in the cost of production, raw materials, or labor. If the cost of materials needed for the production of goods rises, a business may pass these costs onto consumers in the form of higher prices. 

Think back to when the Covid-19 pandemic first appeared, and the production of automobile parts was curtailed at times. What did that do to the price of a car? People were selling used cars for more than they originally paid for them. 

Wages also affect the cost of production and are typically a business’s single biggest expense. When the rate of unemployment is low and businesses are experiencing labor shortages, they may increase wages to attract the right candidates. Increased wages lead to rising production costs – another form of cost-push inflation.

Built-in inflation

As costs rise and workers begin to anticipate spending more, they may start asking their employers for a raise. And employers typically comply so they don’t end up with a labor shortage. If a company increases wages and salaries, and also raises prices to maintain their profit margins, that’s called built-in inflation.

Inflation is a broad measure, and every healthy economy experiences some level of inflation. Inflation is monitored by the central banks of developed economies, including the Federal Reserve in the U.S. The Fed has an inflation target of around 2% – and will tighten their monetary policy and hike rates if prices rise too much or too quickly. 

There are two primary ways the Fed measures inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE).

Types of price indexes

Consumer Price Index (CPI)

Used by the U.S. Bureau of Labor Statistics, CPI is one of the most popular tools for measuring the inflation rate. It tracks price changes for roughly 80,000 different consumer goods and services including gas, food, healthcare, education, and recreation. Changes in this basket of goods and services are considered an approximate measure of the changes in prices across the whole economy. 

Personal Consumption Expenditures (PCE)

PCE also tracks the changes in prices for consumer goods and services, but unlike the CPI, the PCE tracks all items consumed by Americans. While the CPI tracks what households are buying, the PCE follows what businesses are selling. The Fed considers the PCE to be a very reliable economic indicator.

Producer Price Index (PPI)

Another tool to measure inflation is the PPI. It reports price changes for things like fuel, farm products, chemicals, and metals, which all have an impact on domestic producers. If the price increases that cause the PPI to spike are passed onto consumers, that will be reflected in the CPI.

Gross Domestic Product (GDP) Deflator

indicator of inflation levels in the U.S. It measures the aggregate prices of goods and services across the nation and encompasses statistics from both the CPI and PPI.