What is inflation? Definition, explanation, what it means for economy.

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Inflation is hovering near a 40-year high, driven by steep increases in food prices, housing and utilities.

The Federal Reserve is trying to bring it down by aggressively raising interest rates, even if it pushes the economy closer to a recession.

Still, prices are soaring, making it harder for many Americans to get by.

The Consumer Price Index, or CPI report, published on Tuesday and provided 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 gave an idea of whether inflation is beginning to cool.

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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Table of Contents

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.

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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 systems try to get inflation to revolve around a steady percent.

In the U.S., the Federal Reserve System’s target inflation is 2%. This means businesses can increase prices by 2% each year, and the market will still be competitive. 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 on Feb. 14, 2023, indicated that the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.5 percent in January on a seasonally adjusted basis. Over the last year, the all-items index increased 6.4 percent before seasonal adjustment.

The index for ‘shelter,’ meaning the cost of housing, was by far the largest contributor to the CPI increase. That means Americans are paying more on rent and mortgages. Food, gasoline, and natural gas were also contributors.

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 substitution of similar items, 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.

The PCE is what the Fed uses as its gold standard measure of inflation. The Fed has a 2% inflation target.

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 energ,y which are notoriously variable.

Is inflation good or bad?

Inflation is both good and bad, Bivens said.

“The inflation we have today (in 2022) is just bad. It’s too high. It’s too fast,” he 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,” Bivens 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.

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, 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.

“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.

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Why are people taking side hustles?

With inflation surging, more Americans are or are considering taking on extra work to afford holiday purchases along with everyday necessities.

More than four out of five Americans who currently have or plan to take on a side gig, seasonal job, or extra hours at work say inflation played a role in their decision, according to a Neighbor.com survey of 1,000 people taken on Oct. 30.

Additionally, 44% of Americans currently work or plan to work a seasonal job, like shipping packages for Amazon or stocking and unloading for Walmart. And 51% either currently work or plan to work overtime at their current 9-5 job, the survey said.

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Are food prices going to keep going up?

Grocery prices rose by 0.7% from August and are up 13% over the past 12 months. Barclays expects double-digital annual food inflation through January.

In September, the price of rice rose 1% from the previous month and 13.6% from a year earlier. Cakes, cupcakes and cookies jumped 1.8% and are up 16% annually. Pork climbed 1.8% and 6.7% from a year ago.

However, some food prices dipped. Uncooked ground beef fell 2%, and eggs fell 3.5%, though they are still up 30.5% yearly.

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Are imported coffee prices rising?

Over the last two years, coffee prices have steadily increased. According to Nasdaq, the price of coffee reached a high of around $2.50 per pound in February 2022. The last-recorded high price was in October 2014 at approximately $2.21 per pound.

Weather conditions have impacted the production of coffee, especially in Colombia where heavy rains caused complications for crop growth. From February 2021 to January 2022, coffee production in Colombia fell by 11%. In August 2022, Arabica coffee was being traded at a price of $2.43 per pound.

Even in American grocery stores, coffee prices jumped 14.8% throughout 2022, according to data from the Bureau of Labor Statistics. However, since then, the market value of coffee has fallen.

As of February, the price of coffee hovers around $1.80 per pound.

How inflation affects rent

Much like other aspects of the economy, inflation can cause a raise in prices for rent as well. Rent has gone up 0.8% monthly and 7.2% over the past year as landlords responded to an earlier rise in home prices.

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Why are gas prices going back up?

For a third month, gas prices have declined sharply based on falling global demand for oil and recession worries. Pump prices fell 4.9% but were still up 18.2% annually and have moved higher in recent weeks after OPEC announced oil production cuts.

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Where is the housing market heading?

According to Mortgage News Daily, the 30-year fixed mortgage rate on Oct. 24 was 7.29%, marking the highest 30-year rate in 20 years.

Meanwhile, in September, the median sales price for homes in the U.S. was $384,800, an 8.4% spike from the $355,100 price tag last year as prices climbed across the country.

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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.

These core prices increased 0.6% from August following a similar rise the previous month, pushing the annual increase from 6.3% to 6.6%, a new 40-year high.

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