What Is Inflation and Why Does It Matter?
Inflation affects many facets of the economy, from individual purchasing power to interest on the national debt. In recent years, Americans experienced inflation firsthand: pent-up demand, supply-chain issues, government spending, and the war in Ukraine pushed the annual rate of consumer prices to peak at 9.1 percent in June 2022 — the highest rate in 40 years. Since then, actions by the Federal Reserve have helped to control the nation’s rising prices and inflation fell to 2.4 percent year over year in January 2026. Inflation is one of the most closely watched, and politically potent, economic indicators in the country, shaping decisions made by policymakers, businesses, and households alike. Understanding what drives it is essential to understanding how macroeconomic forces shape everyday life.
What Is Inflation and How Is It Measured?
According the Federal Reserve Board, inflation is “a general increase in the overall price level of the goods and services in the economy” (Deflation, on the other hand, refers to the general decline of such prices.) Keeping inflation low and stable is a key goal of the Federal Reserve and central banks around the world. As a result, most have a target inflation rate of about 2 percent, which is widely associated with healthy economic performance.
The way in which inflation is measured is key to monitoring it. Inflation is assessed through a price index, which tracks the change in prices for a basket of goods of services over time. Government agencies such as the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA) produce a number of price indices to help policymakers, business leaders, and consumers track overall price movements. Below are some of the most common price indices:
- Consumer Price Index (CPI) from the BLS tracks the average change over time in prices paid by urban consumers (many other CPI measures also exist). It is commonly used to adjust income eligibility for government assistance, provide cost-of-living adjustments to workers, and adjust benefits for programs such as Social Security.
- Personal Consumption Expenditures (PCE) Price Index from the BEA is the primary index used by the Federal Reserve to monitor inflation. Similar to the CPI, it also tracks prices paid by urban consumers, but the two indices differ in a number of ways; for example, the CPI only tracks out-of-pocket healthcare expenses paid by the consumer whereas the PCE also includes healthcare expenses paid through health insurance on behalf of the consumer.
- Producer Price Index (PPI) from the BLS measures the average change over time in the selling prices of goods produced in the United States. This index differs from the previous two in that the PPI looks at the prices paid by producers — such as prices for intermediate goods — whereas the CPI and PCE only look at the prices paid by the consumer for final products.
- Gross Domestic Product (GDP) Price Index also measures the change in prices paid for goods and services produced in the United States. The GDP price index differs from the PPI in that it includes the prices of goods exported to other countries but excludes imports (vice versa for PPI). The GDP price index is used to adjust economic activity, allowing for a year-to-year comparison of real (inflation-adjusted) GDP.
Some measures of inflation are calculated more narrowly as the change in prices for a specific set of goods and services or even a specific geographic area. Likewise, the change in prices is often reported on an annualized basis but is generally collected monthly.
How is Inflation Different from Other Price Increases?
While inflation is a broad, sustained rise in prices across the entire economy, some price increases reflect entirely different forces. Since prices are sensitive to changes in supply and demand, supply shocks due to trade interruptions, weather events, or global demand can cause relative prices to rise; that is different from inflation because relative price changes do not cause an increase in the general price level economy-wide. For example, in 2025 a spike in the avian bird flu led to the loss of 35 million egg-laying hens. As a result, the average price per dozen eggs hit a high of $6.23 in March 2025; but as the supply rebounded the average cost per dozen is back down to $2.50 as of February. While separate from inflation, those pressures do affect consumers and can make it harder to distinguish between price shocks and genuine shifts in inflationary trends.
There are other cost pressures that are not technically inflationary but can also increase the challenges faced by households in this environment. As the debt rises, it puts upward pressure on interest rates, which make any household debt — mortgages, car loans, small business loans — more expensive. According to the Budget Lab at Yale, five years after a permanent 1 percent increase in the primary deficit an average household could lose anywhere from $300 to $1,250 in purchasing power. Over the long run, that pressure could compound causing an estimated loss of $16,000 per household.
When Has Inflation Occurred in the Past?
There have been several periods throughout the past several decades with high levels of inflation. In the late 1960s during the Vietnam War, low unemployment and strong economic growth pushed up wages — leading to an increase in prices. In the 1970s, high oil prices sparked expectations that other prices would also rise. Those high levels of inflation were brought down in the 1980s due to monetary policy decisions, such as drastically raising interest rates, to lower the amount of money in the economy. However, tackling those high levels of inflation was damaging to the U.S. economy — leading to higher levels of unemployment and two recessions in the early 1980s.
From the mid-1980s until 2020, inflation was low and relatively stable (with fluctuations around recessions). In the years before the onset of the COVID-19 pandemic, inflation remained relatively low despite high employment levels and rapid economic growth — factors that economists previously thought of as strong influences on inflation. In 2022, however, inflation (the CPI-U) surged in the United States — reaching a 40-year high — due to high consumer demand, supply chain issues, government spending, and the war in Ukraine. Monetary policy decisions have helped moderate those rising prices, and annual inflation has gradually declined since. Inflation from January 2023 to January 2024 dropped from 6.4 percent to 3.1 percent and continued to moderate to a low of 2.4 percent in September 2024. Since then, inflation has remained lower than we experienced in 2022 and 2023, averaging 2.7 percent through 2025. In January 2026, inflation fell to 2.4 percent — lower, but still higher than the Federal Reserve's target of 2 percent.
What Causes Inflation?
There are several underlying factors that could cause prices to change. For instance, a surge in government spending or an increase in central bank money printing can cause prices to rise because there is too much money relative to the economy’s ability to produce goods and services.
Inflation can also occur when the price of input goods and services rise. When the cost of such goods rise, so too does the price of the final goods and services that use the input, thereby leading to inflation. An example is an oil shock, which can decrease the supply of oil — in turn increasing the price of oil as well as products across the economy where oil is an input. Another example is war; conflicts can disrupt supply chains, which can cause a shortage of inputs in the economy. If that impacts enough producers, it can lead to price increases in final goods across the entire economy.
Additionally, inflation expectations — the rate at which consumers, businesses, and investors expect prices to rise — also affects inflation as such expectations may be built into wage negotiations and contractual price adjustments for future years. For example, if prices are expected to rise 2 percent annually, then businesses may want to raise the price of their goods to reflect higher expected input costs and workers may request similar-sized wage increases to keep pace with the rising cost of living.
How Does Inflation Affect Businesses and Consumers?
The rate at which prices change can have ramifications across the economy, affecting businesses and consumers alike. For instance, if wages do not rise at the same rate as prices, purchasing power erodes as consumers are no longer able to buy as much with the same amount of money. That raises the cost of living and can also devalue savings.
Changing prices can also create disparities across the economy by distorting the purchasing power for some individuals over time. An example is inflation’s effect on fixed interest payments. For instance, an individual with a fixed 3 percent yearly increase to their pension would lose purchasing power if inflation were higher than 3 percent; the value of their pension would decline. On the other hand, someone with a fixed-rate mortgage of 3 percent would benefit from higher inflation since making those payments would become easier (assuming wages also rose with inflation). That is because debt is tied to a fixed dollar amount rather than to the actual cost of goods. So as inflation rises, borrowers effectively pay back less than they borrowed in real terms. In this way, inflation tends to favor borrowers over lenders.
Finally, inflation makes it more difficult to anticipate how other aspects of the economy may change — such as interest rates, wages, taxes, and profits. That uncertainty could lead to less activity in the economy, such as businesses adjusting hiring decisions or households reducing their spending, and ultimately stunt economic growth.
What Are Some Options for Addressing Inflation?
The Federal Reserve can attempt to contain inflation through a number of monetary policy tools. To avoid the negative effects that rapidly changing prices can have on the economy, the central bank generally tries to maintain stability by keeping inflation (measured through the PCE Price Index) contained to around 2 percent annually. The Federal Reserve can utilize a number of policy tools to achieve that target inflation rate. For example, they can influence how much banks lend to consumers and businesses by changing the discount rate, which is the interest rate banks pay on loans from the Federal Reserve; they can also alter the amount of money banks are required to keep on hand (known as reserve requirements).
However, the most common method for the central bank to contain inflation is the federal funds rate — the interest rate that banks charge one another for overnight borrowing. The federal funds rate influences other interest rates that affect the borrowing costs for businesses and consumers. Therefore, when inflation is too high, the Federal Reserve can raise the federal funds rate to make borrowing more expensive — decreasing the supply of money to lower inflation. On the other hand, if inflation is too low, the central bank can lower that rate to stimulate the economy and move inflation higher. However, the fluctuation of interest rates can have other economic consequences as well — affecting financial markets, employment, indebted organizations, and interest costs on the national debt.
Conclusion
Inflation can affect many facets of the economy — influencing people’s purchasing power, affecting economic growth, and raising or lowering interest costs on the national debt. Understanding and properly managing inflation is just one key element to promoting a healthy, sustainable economy.
Further Reading
With $39 Trillion in Debt, Is the U.S. Headed for More Credit Downgrades?
Three successive downgrades of the U.S. credit rating should alarm elected leaders, but our national debt remains on an unsustainable trajectory.
The Fed Held Its Target Range After Reducing the Short-Term Rate Three Meetings in a Row
High interest rates on U.S. Treasury securities increase the federal government’s borrowing costs.
What’s the Difference Between the Trade Deficit and Budget Deficit?
The terms “budget deficit” and “trade deficit” can be conflated, but they are distinct measurements of important fiscal and economic concepts.