It’s getting harder and harder to ignore prices lately. The cost of a gallon of gas is the highest it’s been in four years. Additionally, groceries, eating out, insurance, utilities, and even basic household goods continue to rise unexpectedly. What’s worse is that economists and the media are warning that what we’re seeing could just be the beginning of more pain to come.
All of this is more than just vibes. The latest inflation report from the government showed that year-over-year inflation recently hit 3.8%. That’s well above the Federal Reserve’s target of 2% and heading in the wrong direction from lower inflation values a year ago.
So what’s going on? Why does it feel like your household budget is more stretched than ever?
Let’s break down what inflation actually is, how it’s measured, why it slowed down after 2022, and what could be done if prices start climbing again.
How Is Inflation Measured?
The simplest definition of inflation is the rising price of goods and services over time. For example, whereas the median price for a house might have cost approximately $200,000 10 to 15 years ago, now it costs closer to $400,000.
To say it another way, inflation is the loss of purchasing power. If it takes $110 a year from now to buy something that costs $100 today, then you interpret that as inflation eroding the value of our money.
Inflation is regularly tracked and measured by the U.S. Bureau of Labor Statistics. There are two common metrics that they report:
- Consumer Price Index (CPI) – This is the most widely known inflation measurement. CPI tracks the average change in prices consumers pay for a wide basket of everyday goods and services, such as food, gas, housing, clothing, transportation, etc. This matters because it directly reflects what consumers experience in daily life.
- Personal Consumption Expenditures (PCE) – This is a lesser-known but preferred inflation gauge used by the Federal Reserve (or Fed for short). While PCE also measures consumer spending, it differs from CPI by using other categories and weightings designed to adjust more dynamically to the changing buying habits of consumers. The Fed prefers PCE because they believe it paints a broader picture of inflation trends across the economy.
What’s an “Okay” Inflation Rate?
As mentioned, the Fed has a target rate of 2% annual inflation based primarily on the PCE index.
You might assume zero inflation would be ideal, but economists generally don’t want it to disappear entirely. A small level of inflation is natural and demonstrates that the economy is healthy and growing.
Therefore, 2% is their so-called “Goldilocks zone.” It’s low enough that prices can rise slowly and predictably without overheating the economy.
Wasn’t Inflation Going Down?
Following the COVID-19 pandemic and several rounds of Federal financial stimulus, inflation in the U.S. peaked in June 2022, hitting a 40-year high of 9.1% over the preceding 12-month period.
During this time, prices reached levels Americans hadn’t seen in decades. Gas surged, grocery costs exploded, and housing expenses climbed rapidly. Many families felt squeezed from every direction.
In response, the Fed stepped in to resolve the issue. The Fed has two mandates:
- Maximize employment
- Maintain price stability
How do they do this? By adjusting something called the Federal Funds rate. This is the rate they set, which then influences nearly every other sector of the economy.
Higher interest rates make loans more expensive, which tends to cool demand across the economy. Again, this had to be done carefully and methodically because if done too aggressively, it could have major negative economic impacts, such as job layoffs or even a major recession.
According to some experts, it worked! In the years that followed, inflation crept down from 9% to the 3% range. However, recent geopolitics, such as imposing tariffs on other countries and war with Iran, have paved the way for economic uncertainty.
What Happens If Inflation Goes Up (Again)?
If inflation continues to trend upward, then it could put the Federal Reserve in a difficult position where it once again needs to raise interest rates to tap the brakes on the economy.
This could have several consequences for American households:
- Rising credit card interest. Interest on credit cards is usually variable, meaning the rates go up if Fed rates go up. If you tend to carry a balance on your credit card, then beware it will incur more interest than normal.
- Higher borrowing costs. Typically, the interest rate for auto loans, student loans, personal loans, and even mortgages goes up when the Fed raises rates. More interest generally means a higher monthly payment.
- Potential market volatility. Often, the financial markets tend to react negatively to rising inflation and the Fed’s actions to curb it. This might result in investment losses and decreased retirement nest egg values.
Should You Panic?
Of course not! Economic cycles of boom and bust are very common. While some businesses may be impacted, many will prevail or even operate as normal.
From your perspective, you can only control what you can control. This means not overreacting and utilizing good financial practices, such as:
- Paying attention to your budget and looking for opportunities to save
- Avoid accumulating purchases on your credit cards and racking up a balance
- Delaying major purchases like buying a new home or vehicle
- Rescheduling costly home projects or renovations
- Use this time to build up your emergency fund
Avoid the temptation to dip into your retirement savings or long-term investments. If the markets are down, then you’ll be forced to sell your assets at a lower price. Plus, when taking money out of retirement accounts, there may be potential penalties and taxes that also must be paid.
The Bottom Line
Inflation has cooled substantially since its 2022 peak. However, recent trends seem to suggest that it may be making a comeback.
While this might entice the Fed to raise interest rates, the effects may only be temporary. Once prices stabilize, the economy will regain its footing and return to normal.
While you can’t control the broader economy, you can focus on strengthening your own financial foundation. Inflation may rise and fall over time, but solid financial habits tend to hold up in almost any economic environment.
Featured image credit: Pexels
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