Breeze Logo

What is inflation? Definition, how to calculate, causes & effects

Reviewed by
Read time
8 mins

Americans are feeling the effects of inflation every time they check out at the supermarket, pay their rent, and fill up at the gas station. Prices continue to rise, and with the war in Ukraine escalating, it seems that there is no good news on the horizon.

Inflation is in the news headlines daily and for good reason. For example, CNBC reported in February that January 2022 data showed that inflation had surged to an annual growth rate of 7.5%, which was the highest since 1982.

If you’re wondering what’s behind this rise in prices, how long it will last, and what you can do to hedge against it, this simple guide to inflation in 2022 will help. In this article, we're going to cover:

Let's dive in.

What does inflation mean?

Inflation Definition: The loss of purchasing power over time: the dollar in your hand will not buy as much tomorrow as it did today.

Inflation is expressed numerically as the annual change in prices for a basket of goods and services. The primary gauge of inflation in the U.S is the Consumer Price Index (CPI), which measures the cost of goods that consumers pay for out of pocket.

The Federal Reserve, which is tasked with keeping prices from increasing too rapidly, targets a 2 percent annual increase in the inflation rate. This gives companies some wiggle room with adjusting to changes in the overall economy and not being forced to lay off workers or go out of business.

How to calculate inflation rate

As mentioned above, the primary source used to find the current inflation rate is the Consumer Price Index.

The formula for calculating inflation is:

Inflation Rate = ((B-A)/A) x 100A = Old Cost; B= New Cost

There are a number of convenient inflation calculators online that can save you some time, like this one from the Bureau of Labor Statistics (BLS) and this one from SmartAsset.

[ Related: 13 best financial tips to help you master your money ]

What causes inflation?

Inflation is often caused by what is referred to as an “overheating economy,” which is an economy in which people have an abundance of extra cash or are accessing a lot of credit, and they want to spend. This enthusiasm by consumers can lead companies to charge more because of strong demand for their products or raise prices because they lack adequate supply.

Many households saved money during the lockdown caused by the pandemic, holding on to government stimulus checks and other payments they received. They also enjoyed watching their wealth rise from a booming stock market and soaring home prices. This extra cash in hand, coupled with a shortage of product availability, is seen as a contributor to high inflation.

World events, like those in Ukraine, can also spur inflation. For example, oil supply disruptions from companies that the U.S. imports oil from, like Russia, can make gas more expensive. Supply chain problems, like transporting oil from refineries to retailers, can also keep fuel in short supply, pushing up prices.

Unforeseen events like the coronavirus can also feed inflation. Shutting down factories because of infected workers and clogged shipping routes have limited the supply of goods like autos and furniture, which has pushed prices higher. With the virus’ effects lessening, airline ticket prices and hotel room rates are also sharply rebounding.

[ Related: What is causing global supply chain issues? ]

Why is inflation bad?

No one wants to see their purchasing power decrease. But is inflation always bad for the economy?

That depends on the speed at which prices are increasing. If they’re spiraling upwards too quickly — often called hyperinflation — they can cause major problems for workers, and entire governments. Out-of-control inflation destabilizes political systems, can seemingly eliminate a country’s middle class, and make it nearly impossible for businesses to budget for the future.

If price gains are more moderate, even slightly above the healthy 2 percent inflation rate, inflation can actually be beneficial for some people, like those who owe money at fixed interest rates.

For example, someone who sells an item for $1 and owes their bank $100 will find their debt easier to repay when they raise the price of the item they sell to $1.05. They’ll need to sell fewer of those items to repay their debt.

For people dependent upon paychecks, whether inflation is good or bad depends upon what happens with their wages. If their pay goes up faster than inflation, they can still thrive in a high-inflation environment. On the other hand, if their paycheck remains the same, their money won’t go as far, and their standard of living may suffer. People on fixed incomes, like students and retirees, find inflation to be more painful than the affluent and those with rising incomes.

Effects of inflation

The economic class that finds it particularly hard to shoulder inflation is the poor, simply because they usually can’t combat rising prices by increasing their income. Instead, they have to cut back on necessities, like food, housing, and gas, not on discretionary items. Wealthier households facing high inflation may need to pare back on things like vacations and dining out, while low-income families may be forced to reduce consumption of essentials, like food.

Poor families may also not be able to take advantage of sales and discounts that sellers are offering, which wealthier families can enjoy. This is because they often lack the available cash needed to time their shopping when temporary discounts pop up and end up spending comparatively more on the same product more affluent families.

Should I ask for a raise because of inflation?

Annual merit increases are usually not enough to counter the ill effects of a high-inflation environment. Workers’ purchasing power is quickly eroded when inflation rates are in the 5-10% annual increase rate when they receive a 2-3% merit increase or performance bonus.

Some economists and advisors agree that now is a good time to request a raise. During an interview with the New York Times on Twitter Spaces, Mary C. Daly, president of the Federal Reserve Bank of San Francisco, encouraged workers to, “Absolutely sit down with your boss and say, ‘I'm a great performer, I do this work, I want to stay with the company, but it’s been harder and harder to make ends meet, and I would like to talk about some compensation to make that easier.”

How to hedge against inflation

You’ll get a variety of answers when you ask financial advisors and experts this question, but there are three strategies that you’ll often hear most: homes, stocks, and gold.

  • A home: A fixed-rate mortgage lets you keep the biggest portion of your living expenses at the same amount each month, regardless of overall consumer price increases. Property taxes and maintenance costs may increase, but your monthly house payment will stay the same. And, with money flooding the market, the price of your home may appreciate, too.
  • Stocks are a good long-term vehicle for hedging against inflation, even though the market may take a short-term hit by worried investors who are anxious over rising prices. Many advisors recommend investing in companies that can raise prices for their goods and services, helping them maintain their profit levels.
  • Gold has been traditionally known as a “safe haven” for investors during inflationary times. It fares well when real interest rates (the current interest rate set by the Fed minus the inflation rate) go into negative territory. Exchange-traded mutual funds allow you to own physical gold or the stocks of gold mining companies.

Rising inflation is a concern for everyone right now. How the Federal reserve reacts and how world events develop remain to be seen and are unpredictable. Regardless, you may want to consider making certain money moves now, like refinancing your mortgage at a lower fixed rate or paying down credit cards and loans that have adjustable rates.

The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.

— Published March 8, 2022
Related Articles

Get started online — anytime, anywhere.

(Seriously, it's a breeze.)