Inflation is the rate at which the general level of prices for goods and services rises and results in a decrease inthe purchasing power of a country's currency.
There are two common measures of inflation: the consumer price index (CPI), calculated by the Bureau of Labor Statistics, and the personal consumption expenditures (PCE) price index from the Bureau of Economic Analysis. Though PCE has some very influential advocates—namely the Federal Open Markets Committee, which uses PCE to guide U.S. monetary policy—CPI is the more popular measure of inflation.
The Bureau of Labor Statistics began calculating CPI in 1919 when it published separate indexes for 32 cities. Two years later, the bureau began regularly publishing a national index representing average inflation in U.S. cities. CPI is expressed as either the month-over-month or year-over-year percent change in prices.
Key Takeaways
- Inflation is a key part of an economy. It is the general level of price increases for goods and services, which reduces purchasing power.
- A healthy level of inflation is needed for an economy, as long as it doesn't get too high or too low.
- Inflation in the U.S. is measured by the consumer price index (CPI) calculated by the Bureau of Labor Statistics.
- The highest year-over-year inflation rate observed in the U.S. since its founding was 29.78% in 1778.
- Since the CPI was introduced, the highest inflation rate observed was 20.49%in 1917.
The Highest Inflation Rate in U.S History
Since the founding of the United States in 1776, the highest year-over-year inflation rate observed was 29.78% in 1778.In the period of time since the introduction of the CPI, the highest inflation rate observed was 20.49%in 1917.
Notably, both of these cases of rapid inflation coincide with major wars, the Revolutionary War and World War I.
Year-over-year inflation is calculated by subtracting the value of the CPI at the beginning of the year and subtracting the value at the end of the year. This result is divided by the value of the CPI at the beginning of the year and multiplied by 100.
CPI data since its formal introduction as an index has been widely viewed as an accurate description of consumer prices in the United States. CPI data before 1913 is more problematic due to under-reporting, over-reporting, lack of data, and different reporting standards utilized.
The Federal Reserve and Inflation
Before the introduction of the U.S. Federal Reserve by the Federal Reserve Act in 1913, the U.S. economy grew in fits and starts. Severe shocks and panics followed periods of rapid inflation and growth in asset prices. Between 1775 and 1913, the United States experienced four separate periods of double-digit inflation.
The U.S. Federal Reserve is mandated to act to moderate inflation using policy measures where it will intervene in currency, debt, and equity markets to achieve this goal. Since the 1980s, the United States has enjoyed a lengthy period of low inflation, with U.S. Federal Reserve chairs often noting concerns regarding deflation rather than inflation.
2%
The annual inflation rate that the Federal Reserve seeks to target.
In the years followingthe 2008 financial crisis, the Fed has keptinterest ratesat historically low levelsand initiated a bond-buying program (since discontinued)known asquantitative easingto help stimulate the economy—although not without its share of outspoken critics.
After the COVID-19 pandemic in 2020 and 2021, inflation started to rise significantly due to supply chain factors, the war in Ukraine, and other economic issues. The inflation rate was 1.6% in March 2021, when it started increasing, and was 5.5% in Dec. 2022.
The inflation rate continued to climb, peaking at 6.6% in Sept. 2022. To combat the rising inflation, the Fed implemented a series of rate hikes in 2022 and 2023. In March 2022, the fed funds target rate was set between 0.25% and 0.50%. By July 2023, the Fed increased it to 5.25% and 5.50%. The interest rate hikes worked to curb inflation, which dropped to 4.1% as of Sept. 2023.
Is Inflation Good or Bad, and Why?
Inflation is the overall increase in prices of goods and services in a given period. Too high inflation is bad for an economy, as it reduces the purchasing power of society; however, moderate inflation is generally considered good for an economy as it serves as an engine for growth.
Who Benefits From Inflation?
Borrowers generally benefit from inflation because the money they pay back on their loans is worth less than it was when they first borrowed money. Banks also benefit from inflation because to combat inflation, the government increases interest rates. Higher interest rates on lending mean more money for banks.
How Do You Combat Inflation?
To combat inflation, the central banks of governments increase interest rates. Increased rates increase the cost of borrowing, as there are higher rates on loans. This makes the cost of goods and services more expensive, which results in consumers spending less. When consumers spend less, demand goes down, and prices follow.
The Bottom Line
Inflation is a normal part of the economy, so much so that the Federal Reserve targets an inflation rate of 2% over the longer run, which corresponds to maximum employment and price stability. When inflation gets too high, it quickly erodes the purchasing power of society, negatively impacting residents. When inflation is too low, it slows the economy and depresses wages. To manage inflation, the Federal Reserve adjusts interest rates to maintain inflation rates at healthy levels.
