Inflation

How Inflation is Measured

The United States government produces several different measures of inflation that serve different purposes and that are followed closely by different constituencies of financial market participants, policymakers, and analysts.

The Consumer Price Index, universally abbreviated as CPI and published monthly by the Bureau of Labor Statistics, is the most widely recognised and most frequently cited measure of consumer price inflation in the United States. The CPI measures changes in the prices paid by urban consumers for a fixed basket of approximately four hundred categories of consumer goods and services including food, housing, clothing, transportation, medical care, recreation, and education. The CPI is available in two primary variants: the CPI-U, which covers all urban consumers representing approximately ninety-three percent of the US population, and the CPI-W, which covers urban wage earners and clerical workers and is used as the basis for Social Security cost-of-living adjustments.

The Core CPI excludes the more volatile food and energy components from the headline CPI calculation, providing a measure of underlying inflation that is less influenced by temporary supply disruptions in commodity markets and that better reflects the persistent inflationary pressures in the broader economy. Because food and energy prices can be highly volatile due to weather events, geopolitical disruptions, and supply-demand dynamics specific to those markets, the core measure is often considered a more reliable signal of the underlying inflation trend than the headline measure.

The Personal Consumption Expenditures Price Index, universally abbreviated as PCE, is the Federal Reserve's preferred inflation measure and the basis for its two percent inflation target. The PCE is calculated by the Bureau of Economic Analysis using a methodology that differs from the CPI in several important respects. The PCE uses a chain-weighted methodology that adjusts the composition of the basket over time to reflect actual consumer spending patterns, while the CPI uses a fixed basket updated periodically through comprehensive revisions. The PCE also uses different weights than the CPI, with a lower weight on housing costs and a higher weight on healthcare spending. These methodological differences typically cause the PCE to run approximately twenty to thirty basis points below the CPI, though the differential can vary meaningfully.

The Producer Price Index, published by the Bureau of Labor Statistics, measures price changes at the producer level for goods and services before they reach consumers, tracking the prices that domestic producers receive for their output at various stages of processing including finished goods, intermediate goods, and crude materials. The PPI is a leading indicator of future consumer price inflation because producer cost increases are typically eventually passed through to consumers, making the PPI a useful early warning signal of building inflationary pressure in the production pipeline.

The GDP deflator, discussed in the GDP article in Section G, provides the broadest measure of price changes in the economy by covering all goods and services included in GDP rather than the consumer-oriented subset covered by the CPI and PCE. The GDP deflator uses a chain-weighted methodology similar to the PCE and is used primarily by economists and policymakers to deflate nominal GDP to real GDP rather than as a practical inflation measure for investment analysis.

The Causes of Inflation

Understanding the causes of inflation is essential for assessing the likely persistence and severity of inflationary episodes and for anticipating the policy responses that inflation will prompt from central banks and governments.

Demand-pull inflation occurs when aggregate demand in the economy exceeds the productive capacity of the economy at current price levels, creating excess demand that pulls prices upward as consumers and businesses compete for a limited supply of goods and services. Demand-pull inflation typically arises during periods of very strong economic growth, expansionary fiscal policy that puts significant additional purchasing power in the hands of consumers and businesses, or very accommodative monetary policy that makes credit cheap and abundant. The COVID-19 pandemic recovery provides a textbook example of demand-pull inflation, with trillions of dollars of fiscal stimulus combined with near-zero interest rates creating enormous demand stimulus that collided with supply chains that had not yet recovered from pandemic-related disruptions, producing the highest inflation in four decades.

Cost-push inflation occurs when the cost of production increases due to rising input prices, reducing the supply of goods and services at any given price level and forcing producers to raise prices to maintain their profit margins. The most common source of cost-push inflation is rising energy prices, as energy is a fundamental input to virtually every production process and transportation activity in the economy. The oil price shocks of 1973 and 1979, when OPEC embargoes and supply disruptions caused oil prices to increase dramatically in a short period, are the classic historical examples of cost-push inflation, generating the stagflation of the 1970s in which high inflation and high unemployment coexisted simultaneously, violating the traditional Phillips Curve trade-off between the two.

Built-in or wage-price spiral inflation occurs when rising prices lead workers to demand higher wages to maintain their purchasing power, and rising wages lead producers to raise prices to cover higher labour costs, creating a self-reinforcing feedback loop that can sustain elevated inflation long after the original supply or demand shock that initiated it has dissipated. The wage-price spiral is the mechanism by which inflation expectations become entrenched, as both workers and businesses anticipate continued inflation and factor those expectations into their wage and pricing decisions, making the inflation self-fulfilling regardless of whether the underlying supply and demand conditions that originally caused it still prevail.

Monetary inflation, the increase in the money supply at a rate faster than real economic growth, is emphasised by monetarist economists in the tradition of Milton Friedman as the ultimate cause of sustained inflation. The quantity theory of money, expressed in the equation MV equals PQ where M is the money supply, V is the velocity of money, P is the price level, and Q is real output, implies that if V and Q are roughly stable, increases in M must be reflected in proportional increases in P. While the relationship between money supply growth and inflation is not as mechanical or as immediate as the simple quantity theory implies, the long historical record across many countries and many episodes of high inflation consistently shows that sustained inflation ultimately requires sustained monetary accommodation.

The Effects of Inflation on Investment Returns

Inflation affects investment returns across all asset classes in ways that are pervasive, complex, and critically important for investment portfolio construction and planning.

Fixed income securities are the most directly and adversely affected by unexpected inflation, because their contractual nominal payments of interest and principal lose purchasing power as prices rise. A bond that promises to pay fifty dollars of annual interest for the next ten years and then return one thousand dollars of principal generates a real return that depends critically on the inflation rate experienced over the holding period. If inflation averages two percent annually, the bond generates a modest positive real return above its nominal yield. If inflation averages five percent, the real return is substantially negative even if the nominal return appears acceptable. The inverse relationship between bond prices and interest rates, combined with the tendency of central banks to raise interest rates in response to inflation, means that unexpected inflation typically produces both capital losses from rising yields and reduced purchasing power of the coupon income.

Treasury Inflation-Protected Securities are the primary financial instrument specifically designed to protect fixed income investors from inflation, adjusting both the principal value and the interest payments to changes in the CPI as described in the Government Bond article. TIPS provide a contractual guarantee of a positive real return above inflation, making them the closest available approximation to a genuinely inflation-protected fixed income investment. The real yield on TIPS, which represents the return above inflation that investors receive, fluctuates with market conditions and can be negative during periods of very high demand for inflation protection.

Equities have a more complex and context-dependent relationship with inflation. In theory, equities should provide a degree of inflation protection over long horizons because companies can increase their revenues by raising prices, allowing their nominal earnings to grow with inflation and supporting equity valuations in real terms. In practice, the relationship between inflation and equity returns is more nuanced. Moderate inflation that is the byproduct of a strong economy tends to be accompanied by strong corporate earnings growth and supportive equity markets. High and unexpected inflation that requires aggressive monetary policy tightening tends to be associated with rising discount rates that reduce equity valuations and economic slowdowns that pressure corporate revenues and earnings.

Real assets including real estate, commodities, and infrastructure tend to provide better inflation protection than financial assets because their values are more directly linked to the price level. Real estate generates rental income that tends to rise with inflation, and property values typically appreciate in nominal terms at least in line with general price levels over long periods. Commodities including energy, metals, and agricultural goods are themselves components of inflation indices and tend to rise in price during inflationary episodes, particularly those driven by supply shocks in commodity markets. Infrastructure assets whose revenues are contractually linked to inflation indices through rate escalation clauses provide particularly direct inflation protection.

Cash and cash equivalents are the most directly harmed by inflation because their nominal value is fixed while the purchasing power of that fixed nominal value erodes continuously as prices rise. An investor holding cash in a savings account earning one percent when inflation is running at five percent is experiencing a real return of negative four percent, losing four percent of purchasing power each year simply through the effect of inflation on the real value of their cash holdings. This inflation tax on cash holdings is one of the most important arguments for maintaining a diversified investment portfolio rather than holding excessive cash reserves beyond those needed for near-term liquidity.

Inflation and Monetary Policy

The management of inflation is the primary responsibility of central banks in virtually every major economy, and the Federal Reserve's conduct of monetary policy is more directly shaped by inflation developments than by any other single variable.

The Fed's two percent PCE inflation target, as discussed in the Federal Reserve article in Section F, represents the committee's assessment of the optimal long-run inflation rate that best serves the dual mandate of maximum employment and price stability. The two percent target is symmetric, meaning the Fed is equally concerned about persistent inflation below two percent as about persistent inflation above it, reflecting the recognition that very low inflation approaching deflation creates its own set of economic problems including the zero lower bound on nominal interest rates that limits the Fed's ability to stimulate the economy through conventional monetary policy.

The transmission of monetary policy to inflation operates through several channels that work with different time lags and with different degrees of certainty. Higher interest rates reduce borrowing and spending by households and businesses, slowing the growth of aggregate demand and reducing inflationary pressure. Higher rates also strengthen the exchange rate, making imports cheaper and exports more expensive, which reduces inflationary pressure through the price of imported goods and through the competitive pressure on domestic producers of goods that compete with imports. The most powerful channel may be the expectations channel, through which the Fed's credible commitment to restoring price stability influences the inflation expectations of businesses and workers, preventing the wage-price spiral that can sustain inflation long after the initial supply or demand shock has dissipated.

The Federal Reserve's credibility as an inflation-fighting institution, established through the Volcker disinflation of the early 1980s and maintained through the subsequent period of low and stable inflation known as the Great Moderation, is one of the most valuable assets of the US monetary policy framework. Anchored inflation expectations, in which households, businesses, and financial market participants expect inflation to remain near the Fed's two percent target over the medium term regardless of short-term inflation fluctuations, are the mechanism through which credibility translates into actual price stability, as self-fulfilling inflation expectations are one of the most powerful forces sustaining elevated inflation once it has become entrenched.

Historical Inflation Episodes and Their Investment Implications

The historical record of inflation in the United States and globally provides important lessons about the investment implications of different inflationary environments.

The Great Inflation of the 1970s, during which US consumer price inflation reached double-digit levels at its peak, was the most severe sustained inflationary episode in modern US economic history and had devastating consequences for both fixed income and equity investors. Bond holders suffered severe real losses as inflation eroded the purchasing power of their fixed nominal payments while interest rates rose dramatically to compensate for the higher inflation, producing large price losses on existing bond positions. Equity investors also suffered, as the combination of higher interest rates that increased discount rates, compressed profit margins from rising input costs, and the uncertainty of the inflationary environment reduced equity valuations dramatically.

The Volcker disinflation of the early 1980s, in which Federal Reserve Chairman Paul Volcker raised the federal funds rate to twenty percent to break the inflationary psychology that had become embedded in the economy, was painful in the short term, producing the deepest recession since the Great Depression, but enormously beneficial in the long term. The successful reduction of inflation from double digits to approximately four percent by 1983 set the stage for the subsequent three-decade period of low and stable inflation that contributed to the extraordinary equity bull market of the 1980s and 1990s.

The COVID-19 pandemic inflation surge of 2021 through 2023 represented the most significant inflation challenge since the 1970s, with US CPI reaching a forty-year high of nine point one percent in June 2022. The surge was driven by the collision of extraordinary fiscal and monetary stimulus with pandemic-related supply chain disruptions, labour market tightness, and pent-up consumer demand. The Federal Reserve's aggressive tightening cycle beginning in March 2022 produced the fastest pace of interest rate increases in four decades, generating significant losses in bond portfolios and equity market volatility while gradually bringing inflation back toward the two percent target.

Inflation in Financial Planning

For financial planners and investment advisers working with individual clients, inflation is a pervasive and critically important consideration in virtually every dimension of long-term financial planning.

Retirement planning must account for the cumulative effect of inflation on the purchasing power of retirement income over what may be a thirty-year or longer retirement horizon. A retiree who needs fifty thousand dollars per year in today's purchasing power will need approximately ninety thousand dollars per year in twenty years if inflation averages three percent annually, requiring a portfolio large enough and invested aggressively enough to generate this growing income stream without depleting the principal. The failure to adequately account for inflation in retirement planning is one of the most common and most consequential errors in personal financial planning, as clients who appear to have adequate retirement savings based on nominal projections may be severely underfunded in real purchasing power terms.

Social Security benefits are indexed to inflation through annual cost-of-living adjustments based on the CPI-W, providing retirees with a built-in inflation hedge for this component of their retirement income. The inflation protection of Social Security benefits makes delaying the start of benefits, which increases the monthly benefit amount, particularly valuable in inflationary environments where the higher starting benefit compounds at a higher rate through cost-of-living adjustments.

Long-term financial goals including education funding, estate planning, and charitable giving must be stated and planned in real rather than nominal terms to ensure that the purchasing power of the goal is maintained over the time horizon of the plan. An education savings plan that targets a nominal amount based on current tuition costs without adjusting for the historically above-average inflation rate of higher education costs will consistently undershoot the actual cost of education at the target date.

The inflation-adjusted or real return is the appropriate measure of investment performance for long-term financial planning purposes, because the goal of investing is to maintain or grow the real purchasing power of capital over time, not merely to accumulate nominal dollars. Presenting investment returns to clients in real rather than nominal terms provides a more accurate and more meaningful picture of the progress being made toward purchasing-power-adjusted financial goals.

Examination Relevance and Key Takeaways

Inflation is tested extensively on the Series 65 examination in the context of macroeconomic analysis, monetary policy, the impact of inflation on different asset classes, investment planning for inflation, and the measurement of real versus nominal investment returns. Candidates must understand the definition and measurement of inflation including the CPI, PCE, core measures, and PPI, the major causes of inflation including demand-pull, cost-push, built-in wage-price spiral, and monetary factors, the effects of inflation on fixed income securities, equities, real assets, and cash, the Fed's two percent PCE inflation target and the monetary policy tools used to manage inflation, and the implications of inflation for retirement planning and long-term financial goal setting.

The core points to retain are these: inflation is the sustained increase in the general price level resulting in declining purchasing power of money; the CPI and PCE are the primary US inflation measures with the PCE being the Fed's preferred measure and the basis for its two percent target; core inflation excluding food and energy provides a less volatile measure of underlying inflationary pressure; demand-pull inflation results from excess aggregate demand while cost-push inflation results from rising input costs and built-in inflation results from wage-price spiral dynamics; fixed income securities are most directly harmed by unexpected inflation as rising yields produce capital losses and fixed nominal payments lose purchasing power; TIPS provide explicit inflation protection through principal and interest adjustments tied to the CPI; equities provide partial inflation protection over long horizons but are harmed by aggressive monetary tightening prompted by high inflation; real assets including real estate, commodities, and infrastructure provide better inflation protection than financial assets; cash and cash equivalents are the most directly harmed by inflation through the continuous erosion of purchasing power; the Fed manages inflation through interest rate policy and forward guidance with the goal of anchoring inflation expectations near the two percent target; and retirement planning must account for the cumulative effect of inflation on purchasing power over decades of retirement using real rather than nominal return assumptions.