What Is Inflation?

What is inflation?

Inflation is the rate at which the cost of goods and services rises over time. Another way to put it is that inflation is a reduction in the value of a certain currency. When inflation happens, consumers can purchase less than they previously could with the same amount of currency. 

As a business owner, you need to understand inflation and how it affects your company financially. In fact, 2 in 3 business owners aren’t paying themselves due to the effects of high inflation. Consumers also need to know the effects of inflation, as it can significantly influence their purchasing power and investment decisions. 

Why does inflation happen?

Inflation happens when the money supply in an economy increases faster than the production of goods and services or when demand outweighs supply. This causes a drop in the value of the currency, which can lead to price hikes on consumer goods.

How is inflation calculated?

Inflation is calculated by the Bureau of Labor Statistics using several economic indexes, including the Consumer Price Index (CPI) and the Producer Price Index (PPI).

• The CPI measures price changes from the perspective of the consumer and tracks price changes in various goods and services. 
• The PPI looks at price changes from the sellers’ perspective by measuring the prices that companies pay for the raw materials used to produce goods. 

The PPI is useful because inflation often begins in the supply chain when, for example, the cost of component parts increases. Manufacturers then charge more for their finished products. 

The Federal Reserve actively works to maintain a maximum inflation rate of 2 percent. When the rate gets significantly higher than this 2 percent target, the Federal Reserve can take several actions to attempt to slow economic growth, including raising interest rates. Learn more about the Federal Reserve’s involvement below.

What are the types of inflation?

There are two main types of inflation: demand-pull and cost-push. 

Demand-pull inflation

Demand-pull inflation occurs when the economy demands more goods and services than are available. If demand skyrockets but supply, or the overall amount of goods and services, remains the same, the demand pulls up the prices for things. 

Imagine you own a bagel shop in your local town. If your community is doing well financially and people love your bagels, the demand for them will increase. If you can’t produce a larger supply of bagels because you don’t have enough ovens, the number of bagels you can sell remains the same. But people want more of them, so the value of your bagels increases, and the price you charge for them can increase as well. 

This is a very simple example, of course. Demand-pull inflation also occurs on a grand scale across an entire economy. 

Cost-push inflation

Cost-push inflation happens when there’s an increase in the cost of production. This can result from increased expenses, like wages, taxes or raw materials. If the cost to make something increases but the demand stays the same, companies might have no choice but to pass those costs down to consumers by raising prices.

In the context of the bagel store example, imagine people love your bagels and want to buy them but a law has changed and you now have to pay higher wages to your workers. Higher wages mean it costs more for you to produce each bagel, which means you’ll have to push prices higher to cover your expenses. 

Other types of inflation

Inflation can combine with other market forces to create an entirely new economic phenomenon. Other types of inflation include the following:

• Hyperinflation: This is a rapid and out-of-control form of inflation.
• Pricing power inflation: This happens when businesses raise prices to increase profits.
• Sectoral inflation: This occurs when the rising prices are confined to just one industry.
• Stagflation: This typically happens when inflation is rising despite slow economic growth.

What is the history of inflation?

From 1914 to 2023, the U.S. has seen an average annual inflationary rate of 3.17 percent. That means, on average, something that costs $100 this year would cost $103.17 next year. 

While the inflation rate has ranged from 1.75 to 6.5 percent from 2000 to 2022, it fluctuated a great deal in the years before. Inflation rates have been tracked officially only for the past 100 years, but they played a significant role in the economy in the decades well before that. For example, between 1775 and 1865, inflation was blamed for two U.S. currency collapses: the Continental currency during the Revolutionary War and Confederate notes during the Civil War. 

In the past century, inflation rates spiked to 18 percent in 1918, 15.6 percent in 1920 and 14.4 percent in 1947. Inflation in the United States has risen above 10 percent only twice since 1980: It topped out at 13.5 percent in 1980 and, a year later, reached 10.3 percent.

Since the financial crisis in 2008, inflation remained below 2.5 percent every year until December 2021, when it rose to 7 percent. The average rate of inflation was 6.5 percent at the end of 2022, but it started a slow decline at the beginning of 2023.

How does inflation affect interest rates?

Inflation can have a major impact on interest rates and, in turn, greatly influence business operations. There are two ways inflation affects interest rates: small-scale and large-scale. 

Loan interest rates for businesses

On a small scale, higher inflation rates can cause the cost of borrowing to increase over time. This makes it more expensive for people and small businesses to take out loans, leading to less spending and investment in the economy. On the other hand, low inflation rates could lead to lower loan interest rates and make it easier for businesses to borrow money and expand their investment. [See our recommendations for the best business loans.]

At the heart of the relationship between inflation and interest rates are real and nominal interest rates.

• Nominal interest rates: These are the interest rates advertised by your bank. An example is the interest accrued on your savings in your savings account.
• Real interest rates: This is the nominal interest rate adjusted for inflation. 

In an economic scenario where there is 3 percent inflation and you have a variable-rate interest loan at 10 percent interest that’s adjusted for inflation, the real interest rate you will pay is 13 percent. In other words, inflation can end up costing you more money. 

Federal Reserve rate

On a large scale, higher inflation can cause federal funds rate hikes that make borrowing more expensive. The Federal Reserve sets the federal funds rate, which is the basis for loans throughout the United States. 

When the federal funds rate is low, interest rates are low and borrowing money costs less, which drives up inflation. When the federal funds rate is high, interest rates are high and it’s more expensive to borrow money, which is a measure that can help curb inflation.

How does the Federal Reserve control inflation?

To help control inflation, the Federal Reserve uses tools such as open market operations, changes to the discount rate and reserve requirements.

• Open market operations involve buying and selling government bonds to increase or decrease the money supply. 
• The discount rate is the interest rate banks pay when borrowing from a Federal Reserve Bank.
• Reserve requirements are the amounts of funds a bank must hold in reserve.

Using these tools, the Federal Reserve can control inflation by controlling the supply and cost of money, thereby affecting market interest rates. However, when it comes to long-term economic growth, other factors, like fiscal policies, including taxes and government spending, may be more effective at controlling inflation. The Federal Reserve also works with other government agencies, such as the Department of the Treasury, to help ensure that the economy remains stable and that inflation is kept in check.

How can you protect your business from inflation?

Inflation is a market force you cannot control, so it’s vital to have both proactive and reactive strategies for inflation. Start by staying informed. If the fed funds rate is low, it’s a good time to take out a loan. If it’s high, it may be better to wait until the rate comes down. 

If inflation is coming and experts are expecting the prices of goods to rise, there are a few strategies you can implement to protect your business. Your main goal should be to free up as much capital as possible to weather increasing prices. 

Reduce debt.

You’ll need more cash on hand to deal with the rising costs of inflation. If you can consolidate debt or pay off creditors before a spike in inflation occurs, you can remain financially flexible.

Optimize business efficiency.

Consolidate departments, rethink business processes, adjust expectations and do your best to stay lean. This could also mean investing in digital infrastructure. Technology can help you automate and streamline processes as well as manage your finances. To get started, see our overview of the top marketing automation software options.

Rethink your suppliers.

Consider which suppliers you’re working with, and do your best to cut costs where possible. This could mean sourcing local suppliers, securing supply contracts or renegotiating existing relationships. As part of your supply chain management procedures, ensure you maintain supplier diversity to minimize disruptions.

Adjust pricing and marketing.

Adjusting pricing regularly can help you stay ahead of inflation’s impact on your business. As prices rise, you’ll need to assess your margin and ensure you’re still making a profit. You may also have to adjust your marketing strategy to help consumers understand why your prices have increased.

Diversify your investments.

Investing in stocks, bonds, commodities and other financial products can provide more income streams to help you deal with any market fluctuations. 

Is inflation good or bad?

While many people think all inflation is bad, economists argue that some controlled inflation is good for an economy. Inflation encourages consumer spending because when dollars are losing value, it provides a disincentive to save those dollars. Inflation also provides companies with the confidence to hire new employees. 

Inflation becomes dangerous only when it’s uncontrolled and unexpected and increases prices quickly to the point that it halts spending and economic activity. In such cases, inflation can be a challenge for businesses to navigate. However, with the right strategies in place and an eye on the market, you can protect your business from the negative effects. By staying informed and making proactive decisions, you can ensure your company remains profitable despite rising prices. 

Matt D’Angelo contributed to this article.