Inflation 101: What is the inflation rate?
The inflation rate refers to the change in purchasing power of a given currency over time. Typically, prices rise, diminishing the value of currency. In periods marked by high inflation rates, rising prices may outpace wages, making it more difficult to buy the things you’re used to.
Keeping track of the inflation rate is a crucial part of your financial planning because it gives you an idea of how well your investments need to perform in order to maintain your standard of living during retirement. While your financial advisor needs to understand the ins and outs of inflation, it is helpful for you to understand as well. Read on to find out how inflation works and how it is calculated.
What does the inflation rate mean?
Inflation is the change in purchasing power over time, and the inflation rate is a measure of how much prices have risen or fallen over a certain period of time. The inflation rate is given as a percentage. For example, an annual 2% inflation rate means that the overall price of goods and services has risen 2% over the course of the year. For example: something that cost $10 last year would cost $10.20 this year.
Inflation is natural in a healthy economy and is typically offset by rising wages. Goods and services may cost a bit more, but workers should generally be earning more as well. Any gap when inflation rises more than wages (or when there’s widespread unemployment) can cause a period of economic downturn, such as a recession.
The primary cause of inflation is an increase in a nation’s money supply. In the U.S., the Federal Reserve can influence the inflation rate by pumping more money into the financial system in the form of reserve account credits (a type of loan to banks).
The inflation rate can also increase due to rising costs of raw materials and production. This is called cost-push inflation. Conversely, demand-pull inflation can occur when demand is higher than supply. Prices may go up, but people are making money and ready to spend it.
What is an example of inflation?
Most of us have first-hand experience with inflation at places like the gas pump and grocery store. Here are two examples of how prices have changed over time:
- Average price per gallon in July 1995: $1.25
- Average price per gallon in July 2022: $4.77
- Average price per gallon in 1995: $2.48
- Average price per gallon in 2021: $3.55
While prices have definitely risen over the decades, wages have as well. In 1965, for example, the average median family income was $6,900, compared to $79,900 in 2021.123
How to calculate the inflation rate
The actual formula for calculating the inflation rate requires just two pieces of data: the price in the current or target year (T) and the inflation base year (B). From there, you can calculate the rate of change as follows:
((T – B)/B) x 100
The answer is the inflation rate as a percentage. Let’s find out the inflation rate of milk between 1995 and 2021 using the prices above.
((3.55-2.48)/2.48) x 100 = 43.15
That means the inflation rate for a gallon of milk over a 26-year period was 43.15%. On an annualized basis, that represents an inflation rate of 1.37%.
In economics, there are many indices used to track a variety of inflation rates. Here is a brief overview of the U.S. Bureau of Labor Statistics’ top inflation indexes.
Consumer Price Index
The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a broad basket of goods and services each month. This information is used to determine the overall pace of annual inflation.
Producer Price Index
The Producer Price Index (PPI) monitors the selling prices of domestic producers. It focuses on the sellers’ perspective rather than the consumers’. Goods, services, and construction products are all included in the PPI.
International Price Program
The International Price Program (IPP) looks at how import and export prices change between the U.S. and other countries.
The presence of inflation is normal and healthy for a growing economy, and we all see the impact it has on the wages we earn and the prices we pay. If you’re wondering how the level of inflation can impact your investment choices and financial planning considerations, that’s a good conversation to have with your investment advisor.
ABOUT THE AUTHOR
Dowling & Yahnke is a fee‐only registered investment adviser. Since 1991, Dowling & Yahnke has provided time-tested, objective financial planning advice and investment management services designed for the financial health and personal freedom of its clients. Located in San Diego, California, the Firm manages approximately $5.7 billion for more than 1,300 clients, primarily individuals, families, and nonprofit organizations.
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