Inflation

Inflation — unevenly rising prices that decrease your purchasing power — occurs when the demand for goods exceeds supply. Learning about inflation and how it affects different markets can help you prepare for any financial impact.

Thomas Brock, CFA, CPA, expert contributor to Annuity.org
  • Written By
    Thomas J. Brock, CFA®, CPA

    Thomas J. Brock, CFA®, CPA

    Expert Contributor

    Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

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    Lamia Chowdhury
    Lamia Chowdhury

    Lamia Chowdhury

    Financial Editor

    Lamia Chowdhury is a financial editor at Annuity.org. Lamia carries an extensive skillset in the content marketing field, and her work as a copywriter spans industries as diverse as finance, health care, travel and restaurants.

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  • Financially Reviewed By
    Stephen Kates, CFP®
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    Stephen Kates, CFP®

    Expert Contributor

    Stephen Kates is a Certified Financial Planner™ and personal finance expert specializing in financial planning and education. Stephen has expertise in wealth management, personal finance, investing and retirement planning.

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  • Updated: November 21, 2022
  • 8 min read time
  • This page features 3 Cited Research Articles
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APA Brock, T. J. (2022, November 21). Inflation. Annuity.org. Retrieved December 6, 2022, from https://www.annuity.org/personal-finance/inflation/

MLA Brock, Thomas J. "Inflation." Annuity.org, 21 Nov 2022, https://www.annuity.org/personal-finance/inflation/.

Chicago Brock, Thomas J. "Inflation." Annuity.org. Last modified November 21, 2022. https://www.annuity.org/personal-finance/inflation/.

What Is Inflation and How Is It Measured?

Inflation is when the prices of commonly used goods and services increase in an economy, impacting the personal finances of consumers nationwide. Inflation occurs when demand exceeds supply, which triggers prices to increase in order to better balance purchasing power.

In the United States, inflation is most frequently measured by the Consumer Price Index (CPI), which is a weighted average of the essential goods and services prices.

CPI Inflation Rate Formula

The CPI is the most widely followed measure of inflation, but the U.S. Federal Reserve utilizes the Personal Consumption Expenditures (PCE) Price Index to inform its decisions. While the CPI measures the change in the prices of goods and services commonly used by urban households, the PCE index measures the change in the price of a broader set of goods and services consumed by all households and the non-profit institutions serving those households.

Stephen Kates, CFP® Headshot
"Inflation is a constant in our lives. When under control, it usually goes unnoticed day-to-day or month-to-month. However, when it spikes, it is easier to notice prices rising and harder to ignore the media reports. Regardless, the best way to handle inflation of any kind is to be on top of your financial situation. This includes understanding your spending and investing strategies and adjusting accordingly when prices or assets change in value."

What Causes Inflation?

Inflation takes effect when the demand for goods and services can’t keep up with supply. The technical imbalance drives up prices as buyers bid up the price of the things they want and need. The larger the imbalance and perceived scarcity of things, the higher the rate of inflation.

factors that influence inflation

The root cause of the imbalance is generally either a demand shock or a supply shock — however, they can occur simultaneously. A demand shock drives demand-pull inflation, while a supply shock drives cost-push inflation.

Demand-Pull Inflation
Occurs when an increase in the supply of money, coupled with an increase in consumer or business sentiment, causes the demand for goods and services to increase more rapidly than an economy’s productive capacity. The imbalance puts upward pressure on prices.
Cost-Push Inflation
Occurs when the costs associated with delivering products or services increase broadly throughout an economy. This can be attributable to many things, but the most common reasons are due to a shortage of materials, geopolitical shocks (such as war, acts of terrorism and sudden trade barriers) and regulatory constraints.

When inflation continues to rise, it can lead people to buy more before prices increase even more. Unfortunately, this accelerates the process, causing present-day prices to spike more quickly.

Inflation in 2022

For the twelve-month period that ended on June 30, 2022, the CPI rose an alarming 9.1% — the largest increase reported in over 40 years. Excluding volatile food and energy products, the measure remains elevated at 5.9%.

A myriad of factors contributed to the price pressure, including COVID-induced supply chain disruptions, surging consumer demand and rising wage pressure across the economy. Geopolitical distress associated with the war in Ukraine also affected inflation rates.

Ultimately, the U.S. is experiencing a technical imbalance, where the demand for goods and services is surpassing the supply. As long as the gap persists, prices will continue to rise.

Since March 2022, the Federal Reserve has been attempting to eliminate the inflationary gap by applying interest rate hikes and other restrictive monetary policies. But so far, its efforts have yet to have a definitive impact.

How Can Inflation Impact Me?

A moderate and consistent level of inflation — arguably, about 2% — is generally considered a sign of economic health. But unexpected and rapid price increases can have a destabilizing effect on the economy and jeopardize the earnings of its people.

The problem is amplified for lower-income households and retirees living on a fixed income. Over time, inflationary pressure can diminish the purchasing power of these consumers, leaving them struggling to cover rising housing costs, food prices, energy bills and medical expenses.

Fast Fact
Deflation is the opposite of inflation — it’s a decrease in the price of goods and services. This may sound appealing, but it has its consequences. Extended deflation can cause an economic downward spiral, resulting in reduced spending and waning confidence. This plagued Japan in the 1990s and early 2000s.

How Does Inflation Affect Different Markets?

When inflation flares up, it’s usually a headlining event that negatively impacts the average consumer. However, depending on the situation, it may not be all bad. Inflation has a differing effect depending on the market.

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Employment Market

In the near term, unexpected inflation can have a detrimental effect on the employment market. Many companies experiencing rising costs are not able to immediately adjust the sales prices of their goods and services accordingly. Rather, they are forced to absorb the costs, which diminishes earnings.

This leads to cost-cutting measures, which often entail budgetary reductions and hiring freezes. In turn, it pushes unemployment rates higher and wages lower. Fortunately, the dynamic is usually short-lived. Over time, as firms are able to raise prices and bolster profit margins, the employment market re-strengthens.

Stock Market

As outlined above, unexpected inflation can have an adverse impact on companies over the near term. This translates to lower stock values, but the impact is not the same for all types of companies. Generally, smaller companies with minimal pricing power and financial ability are more exposed than larger companies with significant pricing power and deep liquidity reserves.

Similarly, growth-oriented and cyclical companies are more exposed than value-oriented and defensive companies.

But don’t put too much emphasis on the near term. With investing, a longer-term focus that reflects your time horizon should support the structure of your stock portfolio.

Real Estate Market

Regarding the real estate market, inflation can be good or bad, depending on your perspective. For prospective buyers, unexpected inflation is generally bad. It drives up both prices and interest rates, which makes acquisitions increasingly expensive and, eventually, unaffordable.

For property owners, inflation has less of an effect, largely due to the inflation-resistant nature of real estate property. Essentially, when you own real estate, you can benefit from two things — an ongoing stream of rental income and price appreciation. Both of these components rise with inflation. While some degree of lag exists, real estate is a great long-term hedge against inflation.

Precious Metals Market

The precious metals market, which includes gold, silver and platinum, is another market that garners a lot of attention during high inflation. Historically, these assets have exhibited a high degree of resilience during prolonged periods of inflation. They have also provided a nice diversifying benefit to portfolios composed primarily of stocks and bonds.

However, precious metals have a major drawback — they do not yield any income. This causes them to significantly underperform when interest rates rise.

How Can I Hedge Against Inflation?

The most effective approach to protect against inflation is to maintain a flexible budget where you can temporarily adjust living expenses during tough times. Not everyone has the advantage of doing this, but for those who can, the benefits can be big. The ability to modify your lifestyle can help you avoid making untimely asset sales, preserve your savings and gain some emotional stability.

Another way to protect yourself is to invest in assets designed to hedge against inflation. Such assets have a high probability of generating increased levels of income in the face of rising prices.

Strategies to Hedge Against Inflation
  • If you have a long investment horizon (at least seven to 10 years) and can withstand a relatively high degree of volatility, hold off on fixed-income holdings in exchange for large stocks. The potential for high return and pricing power of these types of companies can reinforce the real value of your portfolio over the long run.
  • Look to incorporate two other time-tested inflation hedges into your portfolio — gold and real estate. Modest, fund-style allocations to these assets can stabilize the real value of your portfolio while meaningfully enhancing its efficiency (return per unit of risk).
  • Invest in U.S. Series I savings bonds, which are high-quality debt instruments indexed to inflation. Currently, there is no other investment in the world that offers a comparable risk-adjusted return.

A moderate level of inflation is generally conducive to economic health, but rapid inflation can be devastating, especially to low-income households and retirees. Fortunately, certain measures can be taken to hedge this risk. The most effective strategies include maintaining a flexible budget that allows for temporary lifestyle changes and investing in inflation-mitigating assets.

Strive to maintain a holistic view of your investment objectives, which are largely dependent on your time horizon. Don’t lose sight of your need for capital preservation, income generation, growth and liquidity. If you haven’t assessed these requirements or lack a clear understanding of how to do so, it’s recommended you consult with a fiduciary financial advisor.

Other Frequently Asked Questions

What is the relationship between inflation and a recession?
Generally, rapid inflation emerges when an economy is experiencing an unsustainable rate of growth, with too much money chasing too few goods and services. Historically, the U.S. Federal Reserve has attempted to eliminate excessive inflation by implementing interest rate hikes and other restrictive monetary policies to slow things down. Unfortunately, overly restrictive measures can slow the economy more than anticipated, potentially tipping it into a recession.
What is built-in inflation?
Built-in inflation refers to the expectation of a continuous rise in prices over time. It’s a balanced rise in the price of goods and services and the wages of the workers producing those goods and services. Over time, rising labor costs push the prices of goods and services higher. Concurrently, higher costs of living drive workers to demand higher wages. The cycle continues indefinitely, fueling continuous inflation.
What are the advantages vs. disadvantages of unexpected inflation?
At a high level, unexpected inflation is advantageous for fixed-rate borrowers (like individuals with mortgages) and disadvantageous for fixed-rate lenders (like individuals who own bond investments). The former benefit from inflation, because the money they pay back is worth less than the money they borrowed. The latter are hurt by unexpected inflation because the money they get paid back is worth less than the money they loaned out.
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Last Modified: November 21, 2022
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3 Cited Research Articles

Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.

  1. The Federal Reserve System. (2022). About the Fed. Retrieved from https://www.federalreserve.gov/aboutthefed.htm
  2. U.S. Bureau of Economic Analysis. (2022). Personal Consumption Expenditures Price Index. Retrieved from https://www.bea.gov/data/personal-consumption-expenditures-price-index
  3. U.S. Bureau of Labor Statistics. (2022). Consumer Price Index. Retrieved from https://www.bls.gov/cpi/