Inflation

Definition

Inflation is the rate at which the general level of prices for goods and services rises over time — and correspondingly, the rate at which the purchasing power of money falls. If inflation is 3%, something that cost $100 this year will cost $103 next year.

How inflation is measured

In the United States, inflation is primarily measured by the Consumer Price Index (CPI), which tracks the prices of a standard "basket" of goods and services that a typical household buys — including food, housing, transportation, healthcare, and clothing.

The Federal Reserve targets 2% annual inflation as a healthy, stable rate. When inflation runs significantly above that (like the 8–9% seen in 2022), it becomes a major economic concern.

What causes inflation?

• Demand-pull inflation: Too much money chasing too few goods. When consumers and businesses spend heavily, prices rise.
• Cost-push inflation: Rising production costs (labor, materials, energy) get passed on as higher prices.
• Built-in inflation: Workers expect rising prices and demand higher wages; higher wages push prices up further — a wage-price spiral.
• Monetary policy: When central banks increase the money supply faster than economic growth, more dollars chase the same goods, pushing prices up.

How inflation affects your money

Inflation erodes the real value of cash over time. $10,000 sitting in a 0% savings account loses purchasing power every year. At 3% inflation, that $10,000 will only buy what $7,441 buys today — in 10 years.

This is why investing matters. Historically, the stock market has returned roughly 10% annually (about 7% after inflation) — meaning invested money tends to outpace inflation and grow in real terms. Cash savings that don't at least match inflation are effectively losing value.

Inflation and interest rates

The Federal Reserve's primary tool for fighting inflation is raising interest rates. Higher rates make borrowing more expensive, which slows spending and investment — cooling demand and letting prices stabilize. This is why Fed rate decisions are closely watched: they ripple through mortgage rates, credit cards, savings accounts, and the broader economy.

Real vs. nominal returns

When evaluating investments, the nominal return is the raw percentage gain. The real return subtracts inflation. If your portfolio returned 9% in a year with 4% inflation, your real return was about 5% — that's what you actually gained in purchasing power.