What Causes Inflation?

Inflation has been top of mind for many Americans over the last few years, with the dollar not going as far as it used to. Due to inflation, a basket of groceries that cost around $100 pre-pandemic might now cost around $125. Inflation means sustained price increases across a variety of goods and services over time. 

Inflation is not quite the same as other types of price increases, like if you only look at fluctuations in gas prices that can jump up and down temporarily due to a variety of factors. Instead, inflation is more widespread across an economy, though specific commodities like oil can drive broad inflation. 

When inflation occurs, prices generally don't come back down unless there's a significant economic downturn. So, inflation typically causes a permanent loss of general purchasing power, meaning one dollar will buy you less than it used to. Eighty years ago, maybe you could buy 10 cups of coffee for one dollar, whereas now you'd be lucky to buy one.

However, inflation isn't all bad. For one, if prices declined — i.e., deflation — that would mean companies have lower profits, which could mean less hiring, wage freezes, or other cost-cutting measures that ultimately end up hurting economic growth. 

You don't want zero inflation either. Some inflation is actually needed to encourage spending and foster sustained economic growth. And with inflation tends to come higher wages, so while things cost more than they used to, your real purchasing power might not have declined, because you have more money to spend. 

In other words, although a dollar technically doesn't go as far as it used to, that doesn't mean anyone's automatically worse off; instead, the nature of inflation often means that on a relative basis, things stay pretty much the same. Buying a cup of coffee is more expensive than it used to be if you're comparing the literal cost, but it's not necessarily any less affordable than it used to be considering that people make more money nowadays. After all, the average U.S. family income in 1950 was just $3,300.

That said, when inflation rises quickly, it can feel uncomfortable. Sometimes prices rise faster than wages, which can cause significant economic harm. Plus, it can erode the value of some assets, particularly cash-like ones, so if someone has most of their money in a bank account instead of an investment account, inflation can be harmful no matter how much wages increase.

Here, we'll examine what causes inflation. Hint: It's not always one issue; several problems can intertwine.

Demand-pull inflation

One of the most common causes for a rise in prices is when more buyers want a product or service than the seller has available. This is an interesting phenomenon, because unless there's a reason the supply is diminished that affects cost (e.g., a natural disaster that causes a loss of inventory), the price doesn't have to increase. It rises because sellers recognize that buyers are willing to pay more if it's something they really want.

An example of this type of demand-pull inflation would be tickets to a major sporting event. There are only so many seats available (limited supply). More people want to attend the game than the number of available seats (increased demand). Because of this, third-party sellers can charge thousands of dollars for tickets with a face value equal to a fraction of that amount.

On an economy-wide scale, inflation from demand-pull occurs when buyers are eager to spend money and that creates an imbalance in supply and demand (too much demand/too little supply).

"At this point, inflation is mainly being driven by demand," says Callie Cox, chief market strategist at Ritholtz Wealth Management. "Supply chains have healed and goods prices have cooled, but the Fed is laser-focused on services – rent, medical bills, insurance costs, etc."

Factors that increase demand

Demand-pull inflation can be triggered by several factors, such as:

1. Economic growth: When the economy is growing — e.g., companies are hiring and increasing revenue, that can create an inflationary cycle, because as businesses and individuals bring in more money, they have more money to spend. This can cause demand to outpace supply.
2. Increased consumer spending: While increased consumer spending is connected to economic growth, it's worth highlighting separately, as the economy could technically be shrinking, such as if businesses are buying less inventory, but consumer spending might remain strong for a while. For example, consumers might be willing to borrow more and then spend that money, which can fuel inflation. 
3. Government spending: Another factor that can affect economic growth but is also worth considering as its own variable is government spending. When the government spends more, whether that's actually buying more products and services (e.g., military spending) or injecting more money into the economy like providing stimulus checks during the pandemic, that can be inflationary as it increases demand and gives consumers more money to spend.
4. Increased exports: When exports are high, that can be another form of demand that causes companies to raise prices, even if domestic demand is low.  

Cost-push inflation

Sometimes prices rise because costs go up on the supply side of the equation due to rising production costs. These increased supply-side costs, such as materials, wages, and energy, make the product or service more expensive. Therefore the seller has to charge more to maintain a profit, and, if demand keeps up, that can lead to prolonged inflation.

Factors that increase production costs

Several factors can increase production costs and cause cost-push inflation, such as:

1. Supply chain disruptions: When events like geopolitical conflicts or extreme weather slow down supply chains, companies might have to incur additional costs like switching to a more expensive supplier that has capacity or possibly losing inventory and having to reorder. If these costs get passed onto customers in the form of higher prices, it can be inflationary.
2. Increased wages: Higher wages can help counteract inflation, but at the same time, it can trigger inflation because companies might charge more for their products and services to counteract higher labor costs. During the pandemic, for example, labor shortages often caused companies to pay more to attract workers, which then contributed to an inflationary cycle.
   "Limitations on the availability of workers have led to wage increases and higher prices," says Cristian deRitis, deputy chief economist at Moody's Analytics. "Deaths and illnesses related to the pandemic reduced the size of the workforce both directly and indirectly."  
3. Higher energy prices: As mentioned, higher energy prices, like for oil and natural gas, can make production more expensive and cause businesses to raise prices to offset these costs. Because energy prices are volatile, some inflation measures exclude them, but they can still have a real impact in terms of pushing up prices for non-energy-related goods and services. And if companies find that customers continue buying at higher prices, they have little incentive to drop prices, meaning even short-term energy price spikes can sometimes cause sustained inflation.
4. Import costs: If importing goods gets more expensive, such as due to tariffs, then that cuts into companies' profit margins, unless they pass on some of the costs to consumers. When that cost pushing happens, it causes inflation. Changes to exchange rates can also affect import costs. For example, if the value of the U.S. dollar decreases, that makes importing products from outside the U.S. more expensive, because it takes more dollars to buy the same amount of product in another currency.

Built-in inflation

Some inflation can occur as a natural byproduct of typical economic functioning. For example, inflation can occur due to factors such as:

Wage-price spiral 

Wages don't just increase due to labor shortages, like during the pandemic. Typically, people expect to earn more over time. A lot of companies give standard raises, such as 3% to help keep up with the cost of living and reward employees. Yet if companies don't increase their prices at all, it's hard to keep paying those raises, as eventually labor costs would get too expensive. So, there's a self-perpetuating upward spiral of higher wages fueling higher prices which then fuels higher wages to compensate employees for a rising cost of living.

Inflation expectations

Inflation is generally encouraged, as low levels — like the Federal Reserve's 2% annual target — tend to support healthy economic growth. This expectation of some inflation can be a self-fulfilling prophecy. Businesses expect to increase prices over time, and consumers often subconsciously expect to pay more, even though psychologically they're often faced with sticker shock when it happens. 

How the government affects inflation

The actions of governments can affect inflation — sometimes positively and sometimes negatively. There are two main levers the U.S. federal government has in terms of influencing inflation:

Monetary policy

The Federal Reserve, while part of the federal government, is meant to operate independently and manages monetary policy, which is policy around the money supply and borrowing costs. 

Sometimes the Fed tries to encourage low levels of inflation and economic growth by increasing the supply of money in the economy and lowering interest rates, which encourages spending and investment. After the Great Recession, for example, the Fed engaged in a process called quantitative easing (QE) that involved buying securities from financial institutions such as banks, and in doing so, banks had more money to lend to other businesses and individuals. 

The Fed also tried to stimulate the economy through QE and slashing interest rates at the start of the Covid-19 pandemic, but when the money supply grows faster than production capacity, that can create more demand-pull inflation. 

That — plus other unique factors during the pandemic like supply chain backlogs that affected both production costs and enabled companies to raise prices to meet demand — caused inflation to quickly get higher than intended, so the Fed has tried to move monetary policy in the opposite direction to control inflation. That has included the Fed raising interest rates to try to cool down the economy (and therefore stem price increases) as well as letting assets roll off its balance sheet so that there's effectively less money supply, which can help curb inflationary pressures like too much lending.

Note: Government policies and supply chain issues can help create another curious economic condition known as stagflation. This is when the economy is stagnant or contracting, while inflation is high. This condition is very rare.

Fiscal policy

While the Fed controls monetary policy, the legislative branch (Congress) and executive branch (led by the President) control fiscal policy, such as taxation and spending programs. 

Like monetary policy, fiscal policy is sometimes used to encourage economic growth and some inflation, while other times it is used to try to curb inflation. 

For example, when the government issues tax subsidies for products (e.g., solar panels), that can increase demand, thereby helping economic growth, but it can also result in demand-pull inflation. Regulations that increase costs for manufacturers could create cost-push inflation.

To counter inflation, fiscal policy typically is more limited than monetary policy, at least on a short-term basis. Still, decisions like cutting government spending or increasing taxation can help reduce economic demand, thereby curbing inflation. However, this is a delicate balancing act, because when the government pulls back, it can also increase costs on the supply side — e.g., higher taxes might limit spending but can also cause manufacturers to raise prices to maintain the same net profit. 

How to measure inflation

While individuals might measure inflation based on what they're paying for a product or service now vs. in the past, the government uses certain benchmarks that aim to broadly measure inflation across the U.S., such as:

Consumer Price Index (CPI) 

The Consumer Price Index (CPI) is a measure of price changes over time paid by urban consumers for a specific basket of goods and services, such as coffee, shoes, and hospital services. 

The CPI is typically the number you see in news reports about inflation. For example, in June 2022, the CPI showed the annual inflation rate at a post-pandemic peak of 9.1%, meaning prices for that basket of goods and services increased by 9.1% over the previous year.

Personal Consumption Expenditures Price Index (PCE)

The PCE is similar to the CPI in terms of measuring price changes over time. However, the PCE's basket of goods and services adjusts based on consumption trends, and it accounts for both rural and urban consumers, while CPI only looks at urban areas. Also, PCE includes price changes based on purchases made on a consumer's behalf, such as the government paying for medical services for someone on Medicare. The PCE is the Fed's preferred inflation benchmark, and the central bank typically aims for a 2% annual inflation rate based on the PCE.

Producer Price Index (PPI)

The PPI also has some similarities to the CPI, but instead of looking at price changes from a consumer's perspective, it measures price changes based on what producers receive for their goods and services, so it shows inflation at the wholesale level over multiple levels of the supply chain. Thus, PPI and CPI are often directionally similar, but PPI sometimes acts as more of an early signal as to what prices consumers will face.

How to protect your spending power from inflation

There are a variety of common-sense ways to help mitigate the impact of high inflation. DeRitis suggests the following:

• Reduce discretionary spending.
• Put off major purchases.
• Repair automobiles and other major items to extend their life.
• Consolidate credit cards and high-interest loans.
• If it's an option, reduce housing expenses by living with family or having roommates.
• Find a job closer to where you live to reduce commuting costs.
• Increase income with a new job or a second job.

As far as investments are concerned, Cox says: "The most important thing investors can do right now is revisit their 'why.' Understand when and why you need your invested money, and how much risk you can take on to reach that goal."

Cox further advises that you consider investing in sectors that tend to thrive during inflation because they include things people will buy no matter what, including food, energy, and medicine.

DeRitis suggests directing long-term savings toward assets that tend to rise in value along with inflation such as real estate, high-quality stocks, or inflation-protected U.S. Treasury bonds (TIPS).

Also, be aware that inflation can cause changes in the broader economy and affect different people in different ways.

"When prices are rising quickly, many of us consciously — or subconsciously — make different choices in our lives, budgets, and portfolios," says Cox. "We revisit our budgets, cut our discretionary spending, and make personal sacrifices to make sure we can afford what we need. These small changes amount to big decisions, like renting instead of buying a house, choosing one job over the other, or moving cities for better opportunities. Suddenly, your life looks dramatically different. Collectively, the economy suffers from a 'paradox of thrift' – a shift toward savings that ultimately drags on growth."

And deRitis points to large differences across socio-economic groups when it comes to the impact of inflation.

"Higher-income households have been more insulated from the effects of inflation, given that most own their homes with long-term, fixed-rate mortgages that are not affected by rate increases. Lower-income households have been much more exposed to inflation, given that they tend to be renters and spend a disproportionate share of their incomes on necessities including housing, utilities, food, and gasoline."

The keys to financial survival during inflationary times, then, are to reduce spending and expenses, increase income if possible, and put your money in inflation-friendly investments.

FAQs about inflation