A Primer on Inflation — Why Prices Rise, When to Worry

worried expression on a woman's face as she holds a shrinking dollar in front of her

worried expression on a woman's face as she holds a shrinking dollar in front of her

Tetra Images / Getty

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.

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 a little, too. The prices of hotel rooms, gasoline and even bacon have risen sharply in the past 12 months.

But why all the fuss? 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 an average 3.2 percent a year since 1914, according to the Bureau of Labor Statistics, which maintains the index.

The most recent reading of the index was certainly above average: The CPI-U rose 4.2 percent the 12 months ending in April, its largest 12-month increase since September 2008. Its one-month gain of 0.8 percent in April was the biggest since 2009.

Your experience of inflation is probably 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 have children in college, big medical bills or a gourmet appetite, your cost of living has probably increased more than the CPI has. Conversely, if your kids have flown the nest and you have little in the way of medical costs, your cost of living has probably increased less than the CPI has.

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.

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.

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 average annual increase from 1972 through 1981.

What are the effects of inflation?

The 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.

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.

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