The short answer
Inflation is the general rise in prices across an economy over time. When inflation is 5 percent, a basket of goods that cost 100 a year ago costs about 105 today. Put the other way, each unit of money buys a little less.
It is measured as a percentage change over a year, using a price index. Most central banks in developed economies aim to keep it low and steady, around 2 percent a year. Many emerging economies set higher targets.
How inflation is measured
Statistics offices track the prices of a basket of goods and services that a typical household buys: food, rent, energy, transport, clothing, healthcare, education and more. Each item is weighted by how much households spend on it.
- The best-known measure is the Consumer Price Index (CPI).
- Headline inflation includes everything.
- Core inflation excludes food and energy, whose prices swing a lot, to show the underlying trend.
The figure is published monthly, usually as the change compared with the same month a year earlier.
What causes inflation
Economists group the causes into a few kinds:
- Demand-pull: people and businesses want to buy more than the economy can produce, so prices rise. This often follows strong growth, government spending or cheap borrowing.
- Cost-push: the cost of producing goods rises, for example because of higher oil prices, wages or supply-chain disruption, and businesses pass it on.
- Expectations: if people expect prices to keep rising, workers ask for higher wages and firms raise prices in advance, which keeps inflation going.
- Currency weakness: when a country's currency falls, imports such as fuel and food cost more.
- Money supply: if money grows much faster than the economy over a long period, prices tend to rise.
Usually several of these act at once.
Why central banks care, and what they do
High inflation erodes wages and savings, makes planning hard and hits poorer households hardest. So central banks, such as the US Federal Reserve, the European Central Bank and the Bank of England, have inflation targets.
Their main tool is the interest rate:
- Raising rates makes borrowing more expensive and saving more attractive, which cools spending and slows price rises. It can also slow the economy and raise unemployment.
- Cutting rates does the opposite, supporting spending when inflation is low.
These changes ripple through to mortgages, loans and savings accounts. Our explainer on Fed rate cuts shows how.
What inflation means for you
Savings: money in an account paying less than inflation loses buying power. At 5 percent inflation, 100 today buys only what about 61 buys now after ten years. The rate that matters is the real return: your interest rate minus inflation.
Wages: if your pay rises 3 percent while prices rise 5 percent, your real income has fallen about 2 percent.
Debts: inflation reduces the real value of fixed-rate debt, which helps borrowers. But it usually brings higher interest rates, which hurts anyone with variable-rate loans or who needs to borrow.
Planning: at 3 percent a year, prices roughly double in 24 years (the Rule of 72: 72 ÷ 3 = 24). Retirement plans must allow for that.
Inflation, deflation and hyperinflation
| Term | Meaning |
|---|---|
| Inflation | Prices rising on average |
| Disinflation | Inflation slowing, but prices still rising |
| Deflation | Prices falling on average, which can make people delay spending |
| Hyperinflation | Extremely rapid price rises, often defined as 50 percent or more per month |
| Stagflation | High inflation combined with weak growth and rising unemployment |
Practical ways to cope
- Track your own spending. Your personal inflation rate depends on what you buy. A clear budget shows where rises hurt most.
- Shop around for savings rates so your emergency fund keeps up as well as possible.
- Invest for the long term. Diversified investments, such as index funds, have historically beaten inflation over long periods, though not every year.
- Prefer fixed rates on big loans when you expect rates to rise, if the terms are reasonable.
- Negotiate pay with inflation in mind. Our guide to asking for a raise helps.
Key takeaways
- Inflation is the general rise in prices, measured by indexes such as the CPI.
- Many central banks target about 2 percent and use interest rates to steer it.
- It erodes cash savings and wages that do not keep pace.
- Long-term investing and good savings rates help protect your buying power.
This article is general information, not personal financial advice.