What is inflation? Why prices rise, what the rate means, and who it hurts the most.

Over the last year, inflation has been cooling. But from the gas pump to the grocery store, the overall price of living still feels stubbornly high for many Americans.

The Federal Reserve has tried to strike a fragile balance: bring inflation down by raising interest rates, without pushing the economy to the brink.

In August, consumer prices rose 3.7% from a year earlier, up from a 3.2% increase in July. That’s the second straight rise after 12 consecutive declines in annual inflation.

The next consumer price index, or CPI report, will be published on October 12, 2023, at 8:30 a.m. ET. The monthly update provides key information on the prices of various consumer goods and services and how much they have risen over the past month and year. The data also gives an idea of whether inflation is slowing again or accelerating.

While it is easy to see and measure those price changes, it is something else to actually understand them. Inflation can impact many things besides costs, such as employment and wages. 

So, what is inflation, and what causes it? 

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What is inflation? 

Inflation is a "generalized rise in prices," said Josh Bivens, the director of research at the Economic Policy Institute, a left-leaning think tank based in Washington D.C. For example, goods like gas, rent or food can be impacted by inflation. 

"Inflation, though, really is meant to only refer to all goods and services, together, rising in price by some common amount," he explained. 

What causes inflation? 

Inflation can be caused by several factors. The most common is "a macroeconomic excess of spending over the economy's relative ability to produce goods and services," Bivens said. 

In this instance, more people are spending money on goods or services that are not readily available to meet those demands, so producers begin to raise prices.

"If everyone in the economy, tomorrow, decided they weren't going to save any money from their paychecks, and they're just going to spend every last dollar out of the blue, they would all run to the stores and try to buy things," Bivens said. "But, producers haven't produced enough to accommodate that big surge of across-the-board spending. So, you would see prices bid up." 

Another cause of inflation is a lack of producers. If there are not enough workers to produce the demanded good or service, this would lead to an increase in prices as well, Bivens said.

"Labor is the primary component of cost of producing anything," he explained. 

There is also a level of "built-in inflation" within economies, where central banks try to get inflation to hover roughly at a certain level.

In the U.S., the Federal Reserve's target inflation is 2%. This means businesses can increase prices by 2% each year, and it shouldn't impose a cost burden on consumers. Workers can also ask for a 2% wage raise based on these increases, so they can still afford goods and services. 

"That 2% is kind of the built-in inflation; what everyone expects to happen," Bivens said.

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What does CPI stand for?

CPI stands for the consumer price index. It is a metric used by the US Bureau of Labor Statistics to gauge how much the price of consumer goods and services has changed over time.

It can effectively measure inflation in an urban market and give government officials and everyday citizens alike an idea of the health of the overall economy.

The most recent CPI report, released in early August, showed that consumer prices in July rose 3.2% from a year earlier, up from a 3% annual rise in June but far below a four-decade high of 9.1% in June 2022. Month over month, prices increased a modest 0.2%, similar to June.

How is inflation measured?

In the most basic sense, inflation is measured by comparing the current price of goods and services against their recent history.

This is done by looking at a number of government-released data reports.

The CPI is the most prominent of these metrics. Released by the US Bureau of Labor Statistics, the consumer price index measures the prices of goods in an urban market, which represents over 90% of the American public.

The CPI looks at a 'fixed basket' of some 80,000 goods and services to come up with these numbers. What gets put in that basket depends on the consumer expenditures survey which polls Americans to determine which goods are important. The importance of those goods then determines their weight in the CPI– for example, the price of something like gasoline, which forms an integral part of many people’s cost of living, will contribute more than other items.

The CPI does not just have one version though.

Another version – the chained consumer price Index for all urban consumers is used to adjust tax brackets. The virtue of the chained CPI is that it takes into account the product substitutions shoppers make, which happens often when prices go up amid inflation. In doing this, it provides a more accurate look at consumer spending and doesn’t overstate inflation.

Inflation can also be measured through the price index for personal consumption expenditures (PCE). This metric, released by the Bureau of Economic Analysis, takes a more holistic view. Rather than calculating the change in prices for goods paid solely out of pocket for consumers, the PCE takes into account all expenses, including health care coverage compensated by insurance or the government.

The PCE is what the Fed uses as its gold standard measure of inflation.

The final piece of the puzzle to factor in is ‘core inflation.’ This is a term used by economists to reflect the rate of inflation, excluding prices for food and energy which are notoriously variable.

Is inflation good or bad? 

Inflation is both good and bad, Bivens said. However if rates of inflation are consistent, positive and low, they can be beneficial, he added. 

"Inflation is sort of greasing the wheels of the labor market," he said. "It is a way to do some adjustments without actually having to cut nominal wages, and the economy just seems to operate better like that."

If inflation goes beyond its target percentage, though, it can cause uncertainty within the market. 

"Whatever your target is, you don't want to go really far above that. You want people to be able to make plans and have a predictable sense of how much prices and wages will rise over the next year," Bivens said.

How does raising rates fight inflation?

In order to control inflation, one of the Federal Reserve's main tools is the federal funds rate, which is the rate banks charge each other for overnight loans. If that rate rises, banks generally pass on their additional cost to customers.

Even though the Fed does not directly control all interest rates in the country, when it raises the fed funds rate, other interest rates eventually follow, including adjustable-rate mortgages, credit cards, home equity lines of credit, and other loans.

Higher rates curb borrowing and spending, cool off an overheated economy and fend off inflation spikes.

Who is hurt by inflation? 

Whoever is spending most on goods or services can be negatively impacted by inflation. 

For instance, when gas or food prices are inflated, low- and moderate-income families are hurt since they spend a higher share of total income on energy and food, said Bivens. 

Will inflation cause a recession?

Inflation and recession are strongly related, said Bivens. 

High inflation can cause consumers to cut spending and prompt the Fed to raise interest rates - both of which can lead to a downturn. That can result in easing price increases.

"A big rise in the unemployment rate is going to put a lot of downward pressure on inflation," he said. "As the economy slows, inflationary pressures tend to relent." 

A recession isn’t determined by a negative quarter of gross domestic product or even two for that matter. Rather, it’s a significant decline in economic activity resulting from several factors, including high unemployment, a slowdown of goods produced and sold, and wages falling in addition to negative GDP readings.

That’s according to the National Bureau of Economic Research, which gives the official ruling on when a U.S. recession starts and ends.

So, inflation could produce a recession, but it is not a definite outcome.

Are food prices going up?

Consumers were rocked by surging food prices last year. In July, the cost of groceries rose 0.3%. This, however, still pushed down the yearly increase to 3.6%.

The price of rice and bread both rose 0.9%, uncooked ground beef increased 1.5% while cookies rose 0.8%.

Chicken and fish prices both fell 1.1%, bacon was down 0.7% and eggs declined 2.2%. This was the fifth straight monthly decrease for eggs after a series of sharp bird flu-related increases, and costs are now down 13.7% over the last year.

Costs to dine out are up 7.1% over the past year.

How inflation affects rent

Much like other aspects of the economy, inflation can cause a raise in prices for rent as well. And in May, housing costs were the biggest contributor to inflation, according to the Bureau of Labor Statistics.

However, increases have somewhat slowed down. Rent went up 0.4% in July but this is less than previous stronger increases. Annually, rent eased to 8%, according to the CPI report.

What is core CPI?

The consumer price index, or CPI, measures the average change over time in the prices paid by consumers for a variety of different consumer goods and services, according to the U.S. Bureau of Labor Statistics. Core prices exclude volatile food and energy items and generally provide a better measure of longer-term trends. 

They were up 0.2% in July. This left the annual increase at 4.7%, down just slightly from June’s 4.8% increase and well above the Fed's 2% target.