What causes inflation?

Before Covid-19 hit and changed the world as we know it, inflation was notoriously low. For a solid decade, it hovered around 1.7% per year on average, stubbornly below the Federal Reserve’s target rate of 2%. However, in December 2021, the consumer price index climbed 7% over the previous year. Then in February 2022, the CPI jumped to 7.5% and showed prices climbing at the fastest pace in 40 years.

What causes inflation? And what causes the inflation rate to rise? To begin with, people emerged from their homes as lockdown restrictions were lifted and began spending money again. At the same time, the supply of goods and services slowed worldwide. The rule of supply and demand tells us that tighter supply combined with higher demand leads to rising prices – aka, inflation.

But what are those inflation numbers really telling us? How much longer will supply be constrained, and is inflation here to stay? Let’s take a look at pricing and supply trends, and what experts are saying about how long they’ll last.

When you hear the phrase “inflation,” the most common measure is the Consumer Price Index, or CPI, which is the average change over time in the prices paid by urban consumers for a basket of goods and services. There are eight major groups of goods and services: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and “other” – pretty much everything else.

It’s important to understand that a little bit of inflation is good. That’s why the Federal Reserve and other central banks around the world try to keep inflation at around 2%. Modest inflation gives the Fed some room to respond to business cycles.

But at some point, there can be too much inflation. This is called hyperinflation. A common definition of hyperinflation is a month-over-month increase in prices of 50% or more. And, of course, we’re nowhere near that. Many economists believe that scenario is unlikely to happen in a developed economy such as that of the U.S.

To get some perspective, let’s step back a bit. CPI looks at the difference in prices from a year ago. So, the higher inflation numbers we started seeing at the end of 2021 were compared to the levels of the previous year – and, as we’re not likely to forget soon, in 2020 the global economy was dramatically halted. Viewed in this light, the 2021 inflation numbers don’t seem quite as dramatic.

Demand skyrockets, supply struggles to keep up, and before you know it, prices are higher. On the bright side, the economy begins to grow, and people get back to working, traveling and enjoying leisure activities.

But even if the elevated inflation numbers we’ve seen are largely temporary, issues surrounding the supply chain may take longer to work out, if only because there are a number of reasons why supply is under pressure. In some regions of the world, there are labor shortages. In others, raw materials are harder to find and more expensive. Shipping costs are higher. There aren’t enough truckers, warehouses or electronics. The list could go on, but the bottom line is that the global economy isn’t just springing back to normal levels after such a severe and sustained slowdown.

You may be wondering whether you need to make changes to your investments or retirement planning. The short answer is no. And here’s why. The current inflation picture doesn’t change our investment philosophy or our retirement strategy here at Edelman Financial Engines because it was developed to navigate and weather many environments – including inflation. Our investment management experts and planners watch the markets and economic developments every day for our clients, so they don’t have to worry about following – or reacting to – the financial news all the time.

That being said, while a little bit of inflation can be healthy, it can begin to have a more significant impact on your long-term finances over time. For example, food prices have been on the rise, which can take a toll on your budget – especially if you’re on a fixed income.

If you’re concerned about inflation and how it might affect your financial future, connect with one of our independent financial advisors.

The co-hosts of Everyday Wealth are not employees or clients of EFE. They receive fixed cash compensation for acting as host, and have an incentive to endorse EFE and its planners.

The co-hosts of Everyday Wealth receive cash compensation for acting as hosts of the Everyday Wealth™ podcast and for related activities and therefore has an incentive to endorse Edelman Financial Engines and its planners. That compensation is a fixed sum paid on an annual basis; and reimbursement for certain expenses. The amount paid each year does not vary, is not based on show content or any results-dependent factors (e.g., popularity of the show).