What is Inflation? The Hidden Tax on Your Money (And How to Profit)

“Back in my day, we used to pay a nickel for a pack of gum. And we would walk to school, uphill, both ways, in the rain!” – Every Grandparent Ever

I have never understood how you can walk uphill, both ways. If you walk uphill one way, don’t you have to walk back down the same hill to arrive at the original starting point? 

But, I am 100% on board with 5 cent packs of gum! So, what happened, and why are we paying five times that amount now?

What Is Inflation?

It’s a measure of the rate at which goods and services increase in price. The Federal Reserve is in charge of monitoring inflation and their goal is to keep it at 2% per year. (See even the Fed has goals and you should, too!)

Thanks to inflation, prices are constantly going up. Today, the goods you want to buy are lower in price than they will be in the future. Fox example, the $100 item you can buy now, will likely cost $102 a year from now. This makes your dollars more valuable in the present than they will be in the future. 

Since prices are consistently rising, consumers are more willing to spend their money today. After all, the price of the same goods will be even more expensive in the future, and this helps to move the economy along as well. 

What Causes Inflation?

The two main sources of inflation are demand and the amount it costs to produce a good or service. Demand is the number of goods and services that a consumer is willing to purchase.

Consider the demand for gasoline and let’s assume the supply doesn’t change. When the demand for gas increases, there is a shortage, and the price will rise. Or if the demand falls, there will be a surplus, and the price will fall.

The other factor contributing to inflation is the cost of producing a good or service. As you know, businesses exist to make a profit. When the cost of producing their widget increases, their profit decreases. So, for a company to remain profitable and open, they must increase the prices that consumers pay. 

Let’s examine a hamburger restaurant (sorry PETA). If there is a beef shortage, the price will rise. The increase in the cost of beef makes it more expensive for the restaurant to make hamburgers. So, the restaurant will increase the price of its burgers to maintain profitability. Otherwise, the restaurant may risk not having enough money to pay its obligations!

How Is Inflation Measured?

The Consumer Price Index (CPI) and the Producer Price Index (PPI) are the two key metrics used to measure inflation. The CPI tracks changes in the price of goods and services from one period to the next from the consumer’s perspective. This index monitors the expenses in your budget (such as housing, transportation, food) and how they change over time. You can find the latest CPI data on the Bureau of Labor Statistics (BLS) website. 

The PPI is like the CPI. It also monitors how prices fluctuate over time. But, it focuses on the producer or seller’s point of view. The PPI tracks the different components and parts that get used to produce or manufacture goods. A few examples include materials, wages, and fuel. The BLS publishes the latest PPI data too. 

Why Are CPI And PPI Important?

Other than the unemployment rate, these two metrics are the most useful for determining the health of the economy. Not only do they indicate whether the economy is contracting or expanding, but they also help determine the effectiveness of the Fed’s economic policy.

The Fed’s goal is to keep inflation at 2%. If data shows their over the target, it could be a sign that they will take steps to reduce inflation. They accomplish this by raising interest rates or increasing banks’ reserve requirements. This slows lending and the growth of the money supply. 

If inflation falls below the target, they could look to decrease interest rates or reserve requirements. Both of these encourage borrowing which increases the money supply and sparks economic growth.

Inflation And Saving

Saving money is important. It’s the foundation of building wealth and you need to do it to reach your financial goals. But, inflation hurts savers the most!

Currently, the interest you earn on savings accounts is lower than the inflation rate.  As a result, keeping your money in the bank generates a negative real rate of return!