Inflation

Inflation is the rate at which the general level of prices for goods and services rises over time, resulting in a decrease in the purchasing power of money. When inflation occurs, each unit of currency buys fewer goods and services. Moderate inflation is normal in a growing economy, but high inflation can be economically damaging. Inflation is measured using price indices like the Consumer Price Index (CPI), which tracks the cost of a basket of goods and services that typical consumers purchase. The Federal Reserve targets 2% annual inflation as consistent with a healthy economy. When inflation runs significantly above or below this target, the Fed may adjust monetary policy. Several factors can cause inflation. Demand-pull inflation occurs when demand for goods and services exceeds supply. Cost-push inflation happens when production costs rise, forcing businesses to raise prices. Monetary inflation results from expansion of the money supply. In recent years, supply chain disruptions and stimulus spending contributed to elevated inflation. Inflation affects investments in different ways. Cash and fixed-rate bonds suffer during high inflation because their purchasing power erodes. Stocks can provide some inflation protection because companies can raise prices, though high inflation often hurts stock markets in the short term. Real estate and commodities often benefit from inflation as their prices rise with the general price level. For investors, understanding inflation is crucial for long-term planning. The "real" return on any investment is the nominal return minus inflation. An investment earning 8% when inflation is 3% provides a 5% real return. An investment earning 4% when inflation is 5% actually loses purchasing power despite showing a positive nominal return. Inflation erodes the value of future fixed payments, which is why long-term bonds are particularly sensitive to inflation expectations. Investing for the long term requires earning returns that outpace inflation to build real wealth over time.