What inflation is, what causes it, how it's measured, and why central banks target 2%.
Educational content only — not personalized financial, legal, or tax advice.
Inflation is the rate at which prices for goods and services rise over time, eroding purchasing power. When inflation is 5%, what cost $100 last year costs $105 today.
CPI (Consumer Price Index): Tracks the price of a basket of consumer goods and services. The most widely cited measure.
PCE (Personal Consumption Expenditures): The Fed's preferred measure. Broader than CPI and adjusts for substitution effects.
Core inflation: Excludes food and energy, which are volatile. Core inflation reveals underlying price trends.
Producer prices: Measures costs at the wholesale level — a leading indicator of consumer inflation.
Demand-pull: When demand exceeds supply, prices rise. Caused by fiscal stimulus, monetary easing, or consumer confidence booms.
Cost-push: When input costs rise (oil, wages, materials), producers pass costs to consumers. Supply chain disruptions, natural disasters, and geopolitical events trigger this.
Built-in inflation: When workers and firms expect future inflation, they set higher wages and prices, creating self-fulfilling inflation. This is the most dangerous form because it becomes entrenched.
Most central banks target 2% inflation. This level is:
Raise interest rates: Makes borrowing more expensive, cooling demand Reduce money supply: Sell bonds, tighten bank reserves Forward guidance: Signal commitment to tight policy to manage expectations Quantitative tightening: Reduce the central bank's balance sheet
The risk of aggressive tightening is recession — raising rates too much can trigger unemployment and economic contraction.
Benchmark policy rate hikes demonstrate How Interest Rates Work across commercial lending channels, serving as the core mechanism in monetary policy and central banking to suppress demand-pull inflation and stabilize consumer costs against volatile shifts in commodity prices and the economy.
Extreme inflation destroys economies. Zimbabwe (2008), Venezuela (2018-2020), and Weimar Germany (1923) all experienced hyperinflation that wiped out savings, collapsed exchange rates, and caused social upheaval.
The Phillips Curve suggests a tradeoff between inflation and unemployment. This relationship has weakened in recent decades, with both low inflation and low unemployment coexisting, complicating monetary policy decisions.
Structural labor market realignments alter inflation thresholds, showing How Interest Rates Work when central policy must adapt to supply-driven shocks in global commodity prices.