What Is Inflation?

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 high levels of government spending or both — that consumers, flush with cash, drive up prices and employers keep hiking 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.

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, but oil production levels have bounce backed.

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. 

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 certificates of deposit (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?

Often, but not always, it takes a 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.