A country’s inflation rate measures the average increase in the prices of a basket of consumer goods and services. Government agencies collect and compare hundreds of items — from milk to housing — month in, month out, with sophisticated formulas to determine the rate. The inflation rate is one of the most closely watched economic indicators — if it becomes too high, it can erode people’s purchasing power and make it harder for businesses to plan for the long term.
Inflation is also a problem for financial markets, since it can distort the vital relative price signals that drive consumption, production, and labor choices in any market economy. For example, high inflation can make investments in fixed-income assets such as bonds and growth stocks lag behind because it erodes the present value of future cash flows to investors. In addition, high or unpredictable inflation can act as a hidden tax on savings and investment as people save to protect their real incomes from rising prices.
There are many causes of inflation, which vary depending on the economy and geopolitical situation. For example, a rapid expansion of the money supply can cause inflation if it exceeds economic output. This type of inflation is called demand-pull inflation. Another cause is cost-push inflation, which can occur when the increased price of raw materials or labor drives up the prices of final products for consumers. These price increases are often caused by supply-chain bottlenecks exacerbated by geopolitical conflict, such as the COVID-19 pandemic’s semiconductor shortages or a war in Ukraine.