7 factors that cause inflation


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Inflation is when the prices of goods and services rise in relation to the dollar or the currency in use. The result is that the dollar or unit of currency will buy less of just about everything than it previously did.

For people on fixed incomes or those who are in professions where wages don’t rise along with price increases, inflation can be painful. And if inflation becomes hyperinflation – when prices increase by 50% or more in a year – it can destabilize an economy. Inflation is also difficult when it occurs during a recession, a phenomenon known as stagflation.

Here’s a closer look at how to track inflation and seven factors that cause prices to increase.

Related: 5 tips to hedge against inflation

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What Causes Economic Inflation?

The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is compiled by the U.S. Bureau of Labor Statistics (BLS) each month. It tracks the average of prices of a set of goods and services in transportation, food and healthcare.

While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living. Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.

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1. The Economy Is Going Strong

When the economy is growing, more people have jobs, wages rise to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on new luxury items.

In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices.

This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy.

This kind of inflation is sometimes called “demand-pull inflation,” because it is driven by consumer demand. In fact, deflation – when the prices of goods fall for a period of time – can also be considered unhealthy because it can mean demand among consumers is weak.

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2. There is more currency available

Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.

One reason that inflation has been a constant in the US since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.

In response to the COVID-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021.

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3. Basic materials increase in price

In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increase in the prices of manufacturing and shipping for nearly every single consumer good.

Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.

Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.

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4. The housing market takes off

The housing market is a major part of the U.S. economy. And it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.

At the same time, a strong housing market means that homeowners, contractors and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber and oil, which can lead to more inflation.

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The government implements expansionary fiscal policies

The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.

Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.

Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.

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6. New regulations increase costs

While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.

Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.

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7. The exchange rate changes

The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.

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The takeaway

Inflation in the US has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.

Inflation has mostly been gradual since then, but in 2021, economists and market observers have been debating whether inflation could pick up in a significant way again, after stimulus packages during the COVID-19 pandemic and a reopening of the economy boosted asset prices and growth.

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