Inflation

What Is Inflation?

Inflation is a general increase in the prices of goods and services across an economy over a period of time. When inflation rises, each unit of currency buys fewer goods and services than before, so purchasing power falls. It is usually described as an annual rate: the percentage by which average prices are higher than they were a year earlier.

A single price rising is not inflation. The price of one product can climb because of a poor harvest or a parts shortage. Inflation refers to a broad, persistent pattern across many prices. The opposite condition, a sustained fall in the general price level, is called deflation.

How Inflation Is Measured

Economists track inflation by following the cost of a representative basket of goods and services over time. In many countries the most widely cited gauge is the consumer price index (CPI), which compares the current cost of that basket with its cost in an earlier base period. The percentage change in the index is the inflation rate.

Inflation rate = ((Index this year − Index last year) ÷ Index last year) × 100

For example, if the basket costs 200 units one year and 206 units the next, inflation is (6 ÷ 200) × 100, or 3 percent. Other measures, such as producer price indexes, cover different goods and weightings, so they can show different results.

Why It Matters to Investors

Inflation affects the real value of returns. An investment earning 5 percent a year while inflation runs at 3 percent has a real return of roughly 2 percent. Fixed-income investments such as a bond pay set amounts, so rising inflation can erode their real value. Some assets, such as shares in companies able to raise their own prices, may hold up better over time, though not always.

Central banks often respond to inflation by adjusting interest rates. Higher rates can slow borrowing and spending, which tends to cool price growth, but they can also weigh on stock and bond prices. Mild, predictable inflation is generally viewed as less disruptive than high or volatile inflation, which makes planning harder for households and businesses.