Back to Basics: What is Inflation?

Ever felt like you were absent that day in school when they taught everyone else certain terms or strategies for reaching financial goals? In our Back to Basics series, we will break down financial jargon, concepts and anything else you wished you had learned in school about money and our financial systems.

Inflation is a common term discussed in the media, and often spoken about by politicians. What does it mean for you? We’re here to help you learn more about inflation to understand how it impacts your finances.

Inflation is the increase over time in the costs of goods and services within the economy, decreasing purchasing power or the value of currency. Deflation is the opposite – prices decrease and the value of currency increases. 

Simply put, inflation is the rising cost of living, where goods like groceries, fuel, utilities and services, like labor, entertainment or health care, cost more, leaving less money for other purchases. With inflation, your dollar does not stretch as far and your discretionary spending is likely to decrease.

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There are economic theories around inflation that point to different factors. Essentially, inflation occurs when the amount of money in the economy increases. This can happen in a number of ways, like printing more money, legally devaluing currency, or by loaning what is essentially new money into the economy (increasing credit within the economy).

The Federal Reserve (often referred to as the Fed) is tasked, in part, with monitoring inflation and adjusting the supply of money and credit to keep the economy stable. The Fed sets interest rates to help control the supply of money within our economy. When inflation is high, the Fed will often increase interest rates to slow the growth of the economy and control price increases. When the economy feels sluggish, the Fed will lower rates to spur economic activity. Decisions on rate hikes or decreases take time, as do the effects of these actions.

How is inflation measured?

Inflation is most typically measured using the Consumer Price Index (CPI). The CPI, measured by the Bureau of Labor Statistics, is formulated each month using 80,000 goods and services average Americans buy in everyday life such as grocery items and cable bills. The Bureau of Labor Statistics determines which goods and services should be included in the index and how important the good or service is to the average consumer through a survey.

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How does inflation impact my finances?

It depends entirely on how fast inflation rises and how your earnings rise (or fall). If your earnings rise steadily at the same rate of inflation over the course of a few years, you may not notice as acutely how prices are rising. But if inflation jumps up significantly in a short period of time, you might see that the value of your dollar is not stretching as far as it did previously. Because of the impact inflation has on interest rates, you may also want to consider how that impacts purchases you make using loans, like a home or car loan.

There are so many factors that impact economic stability and growth, but that does not mean that your financial future is solely at the whims of the market. Creating a strategic financial plan that accounts for your goals and regularly reviewing that plan can help you weather changes in the economy.

For example, a sound plan that incorporates a diversified investment strategy can help you keep up with inflation in the long term. A well-diversified portfolio is less susceptible to short term ups and downs of the market and that diversification can provide a return rate that helps diminish the effects of inflation.