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What Is Inflation? A Primer on Why Prices Rise and When to Worry

A recent spike in the Consumer Price Index is raising inflationary fears for some

worried expression on a woman's face as she holds a shrinking dollar in front of her
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If you grew up in the 1970s and early 1980s, inflation may be one of the monsters in your closet of economic anxieties. You probably remember gas rationing and soaring prices for everything from Hamburger Helper to halter tops.

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The recent jump in the Consumer Price Index for All Urban Consumers (CPI-U), the government’s main gauge of inflation, probably made you jump, too. The CPI-U rose 8.5 percent over the 12 months ended in March, the biggest increase since 1981.

What is inflation, what causes it, what cures it and how much should you be worried about it now? Here’s a primer on inflation and some tips on how to handle it.

What is inflation?

Put simply, inflation is a rise in prices. The CPI-U, the most commonly used inflation index, measures the average price change in a basket of goods likely to be bought by people who live in cities and suburbs. The index has risen on average 3.1 percent a year since 1914, according to the Bureau of Labor Statistics, which maintains the index.

Your experience of inflation is probably somewhat different from what’s reflected in the CPI-U, which weights each item according to a formula meant to mirror the average household. If you drive a lot, for example, you really felt the pinch: Gasoline jumped 18.3 percent in March alone and 48 percent over the past 12 months. If you love steak, you’re paying on average 16.4 percent more than you did a year ago, and your personal inflation rate might be higher than the government’s average.

What causes inflation?

A simple definition of inflation is too much money chasing too few goods and services. Sometimes the economy speeds up so quickly — because of either low unemployment or government spending or both — that consumers, flush with cash, will drive up prices and employers will hike wages to keep up with rising prices. In the late 1960s, for example, unemployment fell to 3.4 percent, and inflation rose to nearly 6 percent. Currently, the unemployment rate is 3.6 percent, and employers have been offering raises and bonuses to attract and retain employees.

Another way inflation rises is when a sudden shortage of a key material, such as oil, drives prices higher. In 1973, the Arab oil embargo severely reduced the supply of oil. People waited in line for hours to fill up gas tanks, and in 1974, the federal government imposed a 55-mile-an-hour highway speed limit to conserve fuel. The CPI rose 6.2 percent in 1973 and 11 percent in 1974. The COVID-19 epidemic prompted oil companies to reduce production sharply. It has yet to return to pre-pandemic levels and is not expected to until 2023.

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War often sparks inflation: The CPI rose 18 percent in 1918, thanks to shortages of everything from canned goods to copper in World War I. In 1942, as World War II heated up, the CPI gained 10.9 percent. The Vietnam War era combined an overheated economy and massive government spending, which fueled another inflationary spiral. The CPI jumped 13.5 percent in 1980 and averaged an 8.5 percent annual increase from 1972 through 1981. The Russian invasion of Ukraine has meant shortages of oil, food and commodities as other nations have suspended trade with the Russian Federation.

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What are the effects of inflation?

The most obvious effect of inflation is that it makes necessary things harder to afford. For anyone on a fixed income, such as a pension or Social Security, inflation means that your monthly payments buy a bit less every month. Some people find themselves compelled to switch to cheaper cuts of meat, turn the thermostat down in the winter or even skip doses of medicine.

A less obvious effect of inflation is higher interest rates. Bankers who make a loan at 3 percent will lose money — adjusted for inflation — if inflation is at 4 percent. Typically, when inflation starts to rise, so do interest rates charged for mortgages and other loans. For savers, yields on bank CDs and money market funds will typically rise also, though perhaps less quickly than the rates banks charge for loans.

Inflation is cumulative, because prices rarely go down after they go up. A $100 monthly payment will have the purchasing power of about $82 after a decade of just 2 percent inflation. Because of inflation’s long-term effect on retirees, Congress in 1975 authorized annual cost-of-living adjustments for Social Security beneficiaries.

Wildly out-of-control inflation, typically aided by central banks continually pumping out more money, is called hyperinflation. In Germany in 1923, for example, consumer prices doubled every few days. During these periods, people often trade their money for more stable currencies or gold, and political unrest is common. The instability of the German economy in the 1920s was one reason Adolf Hitler rose to power.​

What cures inflation?

In a word, recession. When unemployment rises, consumer demand slackens and prices tend to stabilize — or at least stop rising so rapidly. In the 1980s, the Federal Reserve sent short-term interest rates soaring in an effort to slow the economy and reduce the supply of money pouring into the system. Businesses and consumers tend to slow their spending when it becomes more expensive to borrow money. The interest rate on a 30-year conventional fixed mortgage hit a staggering 16.63 percent in 1981.

Although the Fed tries not to induce a recession — central bankers aim for what they call a “soft landing” — rising rates often do exactly that. The rising interest rates in the 1980s caused two short, sharp recessions, and inflation has remained largely contained since then.

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What has caused the current spike in inflation?

Economists say the current bout of inflation has been mainly caused by supply interruptions during the COVID-19 pandemic. “Anybody who thought that they had a playbook for either closing down the economy or opening it back up didn't look closely enough at the shelf,” says Mark Hamrick, Washington bureau chief for Bankrate.com.

For example, something as seemingly mundane as car rental rates have soared because demand for rentals evaporated during the pandemic, and rental car companies sold off big parts of their fleets. When the economy started opening back up, these companies had trouble finding enough cars because a computer-chip shortage hindered many car manufacturers from producing new cars. “The virus ended up being a supply shock, and a global one,” Hamrick says.

Those shocks should ease later in the year, although March’s red-hot readings will boost the year’s 12-month inflation rate. “My December 22 year-on-year headline and core estimates are now 5.1% and 3.9%, respectively, with six-month annualized rates at 2.9% and 3.2%,” says John Vail, chief global strategist at Nikko Asset Management. (The core inflation rate strips out the volatile food and energy categories.)

Even if the current bout of inflation is temporary, it’s a wake-up call to keep some emergency savings on hand, Hamrick says — and one that the public has heeded. The current U.S. personal savings rate soared to 27.6 percent in March 2021, the second-highest rate ever. It’s now down to 6.3 percent as Americans rev up their spending again. “It looks as if this experience helped to crystallize for many Americans the need to save for emergencies in the future,” he says. “It’s not a question of what will present itself in the sense of an emergency down the road, whether it’s a dental expense … or an interruption in income or employment. It’s just a question of when and if.”

John Waggoner covers all things financial for AARP, from budgeting and taxes to retirement planning and Social Security. Previously he was a reporter for Kiplinger's Personal Finance and USA Today and has written books on investing and the 2008 financial crisis. Waggoner's USA Today investing column ran in dozens of newspapers for 25 years.

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