The inflation rate measures the average change over time in prices for a basket of goods and services that people buy on a regular basis, like food, housing, transportation, and education. Government agencies, such as the Bureau of Labor Statistics (BLS), produce a variety of price indices to help policymakers, business leaders, and consumers track overall price movements. The Consumer Price Index (CPI) is one of the most popular. It tracks prices paid by urban consumers, and it’s used to adjust income eligibility for government assistance programs, as well as for cost-of-living adjustments for workers.
Inflation is a complex and dynamic process that changes relative prices, wages, and rates of return throughout the economy. Depending on how, where, and when new money enters the economy, inflation can push up some products and prices before others (known as Cantillon effect). This cyclical process can also affect savings and investment returns.
A key factor in determining the rate of inflation is expectations. When people and businesses anticipate that prices will rise, they may build this into wage negotiations or contractual pricing adjustments (such as automatic rent increases). These expectations can become self-fulfilling.
When inflation is too high, it can chip away at the value of saved money and reduce investment returns. It can also reduce the real purchasing power of workers and retirees. Many investors aim to increase their long-term purchasing power through investment, but inflation can make this difficult and sometimes even impossible. This is why it’s important to bake in an expected inflation rate when creating a savings plan.