We’ve all heard about inflation a lot in the last year. Prices have increased 9% on average over the past 12 months, according to the latest data from the Bureau of Labor Statistics.
Inflation is an economic term for the rising prices of goods and services, which usually happens gradually. But the inflation rate we’ve seen recently is far from gradual, hitting levels the U.S. hasn’t seen in 40 years.
Here, we’ll break down a few different types of inflation and what they can mean for your wallet.
What Is Inflation?
It’s generally understood that there will always be inflation—rising prices that reduce the purchasing power of your dollar—in a growing economy. But economists prefer to see prices rise slowly. The U.S. central bank, the Federal Reserve, aims for a slow-and-steady inflation rate of about 2% per year.
When inflation climbs faster than usual, it can rattle consumers who aren’t expecting to pay higher prices for gas, groceries, clothing, rent and numerous other products and services.
That stress consumers feel during periods of inflation can lead to the country collectively becoming less productive, says Peter C. Earle, an economist at the American Institute for Economic Research, a libertarian think tank in Massachusetts.
“Prices rise unevenly, and it becomes difficult for consumers to determine what the best price for a certain good or service is at a particular moment,” Earle says. “So more time is spent seeking and comparing prices in order to get the lowest purchase price.”
One historical example: Rapid inflation in the early 1970s contributed to gas shortages, during which consumers spent hours waiting in line to pay high prices for fuel.
What Are the Three Main Types of Inflation?
There are three primary types of inflation:
- Demand-pull inflation
- Cost-push inflation
- Built-in inflation
Right now, the country is dealing with all three major types of inflation, which is rare, according to Christopher Blake, assistant professor of economics at Oxford College of Emory University. “The story is complicated in a way that it hasn’t been in 40-plus years, given that we usually only see one form of inflation or the other,” he says.
Demand-pull inflation describes how demand for goods and services can drive up their prices. If something is in short supply, you can generally get people to pay more for it.
Are you still paying for plane tickets for a vacation despite prices being considerably higher than normal? That’s a good example of demand-pull inflation.
The U.S. is experiencing demand-pull inflation due to wages rising and Americans having a decent amount of money in their savings accounts, Blake explains, although some consumers are starting to empty those accounts.
“Consumer spending has remained high, despite the rising prices we currently see,” Blake says. “This is commonly referred to as demand-pull inflation, as consumer demand pulls prices higher because firms cannot keep up.”
Cost-push inflation often kicks in when demand-pull inflation is going strong. When raw materials costs increase for businesses, the businesses in turn must raise their prices, regardless of demand.
“Increases to the prices that producers face put businesses in a tough spot,” Blake says. “They can either accept higher costs and keep their prices the same, or they can respond by trying to keep their profit margins the same.”
When the price of chicken keeps going up, for example, eventually your favorite restaurant will need to charge more for a chicken sandwich.
As demand-pull inflation and cost-push inflation occur, employees may start asking employers for a raise. If employers don’t keep their wages competitive, they could end up with a labor shortage.
If a business raises workers’ wages or salaries and tries to maintain profit margins by raising prices, that’s built-in inflation.
Now, if you learn about your favorite coffeehouse raising prices due to the climbing cost of coffee beans, you’re a victim of cost-push inflation.
And if you’re going to buy that coffee even though the price is uncomfortably high, you’re engaging in demand-pull inflation.
How Is Inflation Typically Measured?
There are two primary ways that the federal government measures inflation.
The Consumer Price Index (CPI) is a tool that the U.S. Bureau of Labor Statistics uses to track inflation, but it’s not the only indicator.
The federal government also uses the Personal Consumption Expenditure price index (PCE). Here’s how each index works and which one the Federal Reserve considers a more reliable indicator of inflation.
Consumer Price Index (CPI)
The Consumer Price Index, produced by the Bureau of Labor Statistics (BLS) measures price changes for about 80,000 different goods and services, including food, fuel, and clothing and expenses such as daycare and preschool costs, college tuition, and funeral expenses.
When you hear that prices have gone up 9% in the past 12 months, that’s an average of all the items the CPI tracks prices for. Individual goods and services can vary: Chicken prices went up almost 19% in the last 12 months, while haircuts are 6.3% more expensive than they were last summer.
That 9% price difference over 12 months is known as “headline” inflation. Some economists prefer to examine inflation without considering food and energy prices, which can fluctuate a lot from month to month. “Core” inflation looks at price changes but excludes food and energy prices. The CPI also typically reports a higher inflation rate than the other main indicator, the Personal Consumption Expenditures Price Index.
Personal Consumption Expenditures (PCE)
The Personal Consumption Expenditures Price Index (PCE) tracks the changes in prices of consumer goods and services, and if that sounds an awful lot like what the CPI does, that’s because it is—but there are key differences, including that the PCE tracks all items that Americans consume, not just those you pay for out of pocket.
Another key difference is that the CPI follows what households are buying; the PCE analyzes what businesses are selling.
If that sounds clear as mud, think of your health care. The CPI tracks medical service expenses that consumers pay for, whereas the PCE also includes health care services that are paid for by an employer-sponsored health insurance plan, Medicare or Medicaid.
Or here’s another distinction: If the cost of beef goes skyrocketing and people instead start purchasing chicken, the PCE price index will pick up on that.
As far as the Fed goes, the PCE is the steak, and the CPI is the sizzle. They’re both important, but the Fed considers the PCE to be a more reliable indicator.
What Type of Inflation Are We Seeing Now?
The United States is experiencing, as noted, all three of the main types of inflation. But it’s not just the U.S. that’s suffering. Record inflation around the globe is being blamed mainly upon higher wages, energy prices and interest rates.
The Covid-19 pandemic, of course, was the match that lit the inflationary flame. As people got sick and couldn’t work, that affected the supply chain, which in turn affected prices for limited supply. The war in Ukraine hasn’t helped either, causing a ripple effect that has made oil and food prices go up.
In the U.S, the Federal Reserve has been raising interest rates to make borrowing more expensive—an act that often puts the brakes on inflation. The challenge for the Fed, however, is to not raise interest rates too much. Benchmark interest rates are currently at a range of 1.5% to 1.75%; near the beginning of 2022, they were close to zero.
You might think, why not just set interest rates to 5% and end inflation right away?
If you raise interest rates too much and too quickly, the Federal Reserve risks creating a recession. One potential consequence of interest rates for borrowing going way up is that a business owner may not feel like they can afford to take out a loan to invest in their company. If enough businesses stop borrowing money to grow their businesses, the economy starts to shrink, instead of continuing to grow.
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