From the mid-1980s until 2020, inflation was low and relatively stable (with fluctuations around recessions). Even in the years before the onset of the COVID-19 pandemic, inflation remained relatively low despite high employment levels and strong economic growth — factors that economists previously thought of as strong influences on inflation. In 2022, however, inflation surged in the United States — reaching a 40-year high of 8.5 percent in July 2022 — due to high consumer demand, supply chain issues, government spending, and the war in Ukraine. Monetary policy decisions, in addition to the easing of supply chain disruptions and other factors, have helped tame those rising prices, as annual inflation has been gradually declining, reaching 2.9 percent in July 2024.

What Causes Inflation?

There are several underlying factors that could cause prices to change. For instance, when the supply of money increases relative to the size of an economy — whether due to a surge in government spending or a central bank printing too much money — prices can rise. Likewise, events that raise production costs or disrupt the production of goods in the economy, such as wars or natural disasters, can also lead to an increase in prices. Both of those scenarios are examples of demand-pull inflation, a type of inflation that occurs when there’s too much money relative to the economy’s ability to produce goods and services.

Inflation can also occur when the price of input goods and services rise, known as cost-push inflation. When the cost of such goods rise, so too does the price of the final goods and services that use the input, thereby leading to inflation. An example of cost-push inflation is an oil shock, which can decrease the supply of oil — in turn increasing the price of oil as well as products across the economy where oil is a component.

Finally, inflation expectations — the rate at which consumers, businesses, and investors expect prices to rise — also affects inflation as such expectations may be built into wage negotiations and contractual price adjustments for future years. For example, if prices are expected to rise 2 percent annually, then businesses may want to raise the price of their goods by 2 percent and workers may request similar-sized wage increases.

The inverse of the causes noted above can also place downward, or deflationary, pressure on prices. Cheaper inputs, negative inflation expectations, and decreased demand for goods and services — especially during an economic recession — can all lead to a decline in prices.

The various drivers of inflation can also influence how long inflation persists. For example, an oil shock or a temporary increase in government spending may only lead to short-term bouts of inflation. On the other hand, sustained periods of increased government spending or excessive printing of money can lead to longer periods with high inflation and potentially hard-to-control “spirals” where price increases feed subsequent price increases.

How Does Inflation Affect Businesses and Consumers?

The rate at which prices change can have ramifications across the economy, affecting businesses and consumers alike. For instance, when high levels of inflation occur, the value of one’s money (also known as purchasing power) erodes, as consumers are no longer able to buy as much product with the same amount of money. Likewise, if wages do not rise at a similar rate as prices, inflation can devalue people’s wages and savings and increase the cost of living.

Changing prices can also create disparities across the economy by distorting the purchasing power for some individuals over time. An example of this is inflation’s effect on fixed interest payments. For instance, an individual with a fixed 3 percent yearly increase to their pension would lose purchasing power if inflation were higher than 3 percent, as the value of their pension would decline. On the other hand, someone with a fixed-rate mortgage of 3 percent would benefit from higher inflation as making those payments would become easier (assuming wages also rose with inflation).

Finally, inflation and deflation make it harder to anticipate how other aspects of the economy may change — such as interest rates, wages, taxes, and profits. That uncertainty could lead to less activity in the economy, such as businesses adjusting hiring decisions or households reducing their spending, and ultimately stunt economic growth.

What are Some Options for Addressing Inflation?

The Federal Reserve can attempt to contain inflation through a number of monetary policy tools. To avoid the negative effects that rapidly changing prices can have on the economy, the central bank generally tries to maintain stability by keeping inflation (measured through the PCE Price Index) contained to around a 2 percent annual increase. The Federal Reserve can utilize a number of policy tools to achieve that target inflation rate. For example, they can influence how much banks lend to consumers and businesses by changing the discount rate, which is the interest rate banks pay on loans from the Federal Reserve; they can also alter the amount of money banks are required to keep on hand (known as reserve requirements).

However, the most common method for the central bank to contain inflation is the federal funds rate — the interest rate that banks charge one another for overnight borrowing. The federal funds rate influences other interest rates that affect the borrowing costs for businesses and consumers. Therefore, when inflation is too high, the Federal Reserve can raise the federal funds rate to make borrowing more expensive — decreasing the supply of money to lower inflation. On the other hand, if inflation is too low, the central bank can lower that rate to stimulate the economy and move inflation higher. However, the fluctuation of interest rates can have other economic consequences as well — affecting financial markets, indebted organizations, and interest costs on the national debt.

Conclusion

The rate at which prices change can affect many facets of the economy — influencing people’s purchasing power, affecting economic growth, and raising or lowering interest costs on the national debt. Understanding and properly managing inflation is just one key element to promoting a healthy, sustainable economy.