What Are The Common Effects Of Inflation On The Economy And Your Life?

Have you ever picked up an item in the store – perhaps an item you’ve purchased on many occasions – only to be shocked by a higher price when you reach the checkout counter? If so, you’re no stranger to inflation. But the short- and long-term effects of inflation are more varied and complex than the increased cost of consumer goods.  

You probably learned about inflation in your high school economics class, but how much can you remember? We’re here to fill in the gaps and don’t worry – there won’t be a test at the end.

In economics, inflation means a general increase in the prices of goods and services over a period of time, which leads to a general decrease in the purchasing value of a dollar. Although there are peaks – moments in time where inflation rates reach higher levels --inflation itself is an important component of a healthy economy.

Though the Federal Reserve has not established an official inflation target, experts and policymakers generally consider inflation rates acceptable when they are around 2%. Over the last decade, the average inflation rate in the U.S. has been around 2.42%.

So, what drives inflation rates? Variations in the supply and demand of different goods and services can ultimately lead to an increase in the costs associated with those goods and services, but a rise in inflation can also be caused by several other factors, including:

• Policy changes: From lowering interest rates to cutting taxes, fiscal policy can directly impact the rate of inflation.
• A wage-price spiral: This term refers to the relationship between rising wages and rising prices. When consumers receive a boost in income, they have a higher demand for goods and services, which then raises prices.
• Bottlenecks in the supply chain: Supply constraints and shortages limit the inventory of an item, which can cause inflation to rise.
• Changes in the cost of materials: Production costs play a key role in determining the prices of consumer goods. When it costs more to make a product, the product itself costs more to buy. This is called cost-push inflation.

As referenced earlier, inflation itself is neither good nor bad. Although high rates of inflation can make consumers feel the value of their money is dwindling, without any inflation at all, the economy would be unable to grow. To help you better understand all the facets of inflation, we’re exploring both the positives and the negatives.

Affordability is a top priority for most consumers, so it’s not surprising that many see inflation as a negative. But in reality, inflation can have numerous positive effects.

Keeps Deflation Under Control

Inflation helps to keep prices relatively stable and avoid deflation, which refers to a general decrease in the prices of an economy. Although a price decrease may seem appealing on the surface, deflation ultimately leads to lower incomes and less consumer spending, which in some cases can lead to a recession or full-blown depression.

Encourages Spending And Investing

If you’ve had items in your online shopping cart for a week and hear that the cost of those items is about to go up, would you feel more inclined to make the purchase now? More often than not, the answer is yes – and this is the primary reason that a rise in inflation can actually lead to upticks in spending and investing despite high prices.

Lowers Debt Service Costs

Did you know that high levels of inflation can actually help to reduce debt service costs? For borrowers making debt payments with a relatively low interest rate, an increase in inflation – when paired alongside an equal increase in their wages – can lead to less of their monthly income going toward debt payments.

Reduces Unemployment

In the short term, higher inflation can reduce unemployment rates and encourage economic growth. Historically, inflation spikes have led to an increased demand for employment while also prompting businesses to invest in human capital, but these positive effects on the economy lessen when high rates of inflation persist over a long period of time.  

For all the positives associated with inflation, there are some impactful negatives to consider as well.

Disproportionately Impacts Low-Income Households

When looking at inflation, it’s important to understand how socioeconomic status impacts its effects. Low-income households will feel the negative effects of inflation much faster and deeper than those with medium to high-incomes. This is because low-income consumers tend to have less buffer in their budgets to cover the added cost when inflation rates rise.

Raises Cost Of Living

When the cost of necessities like food, utilities and housing rises, it leads to consumers forking out more of their hard-earned cash each month. This may not be a dealbreaker for those with incomes that adjust with inflation, but for those without raises, this means an increased cost of living across the board.

Raises Interest Rates

Inflation effects more than just the cost of goods and services – it also directly impacts interest rates. The Federal Reserve adjusts these rates as a way to manage inflation, so if measurements indicate higher levels of inflation, the Fed responds by raising the benchmark federal funds rate, which in turn raises minimum interest rates as well.

This is done to minimize the opportunity for risky or volatile investments, though rising rates can also make it more challenging for borrowers to afford even the soundest of investments.

Hurts The Growth Of Stocks And Bonds

Rising inflation can also negatively impact the growth of bonds, as increasing interest rates lead to decreasing market prices, therefore proportionally dropping the yield the bonds may have had when inflation was lower. Similarly, stock investments typically have a lower rate of return when inflation is high.

If you’re in the market to buy a house, you might be wondering how inflation affects mortgage rates. And although inflation doesn’t impact these rates directly, indirectly it can play a major role.

As previously mentioned, increases in inflation typically lead to the Federal Reserve raising the federal funds rate, which sets off a chain of events that ultimately leads to rising interest rates with both fixed-rate and adjustable-rate mortgages. This is because raising the federal funds rate makes it more expensive for banks and lenders to lend money to borrowers. But alongside rates, inflation can also directly impact housing prices and inventory.

Inflation isn’t all good or all bad. A rising rate of inflation at the right time can encourage positive economic growth. But of course, it’s important to consider all of the positives and negatives when thinking about inflation and how it impacts your day-to-day life as a consumer.

And for prospective home buyers, it’s important to recognize that inflation will continue to impact the housing market in the coming months. So, if you’re ready to purchase a home, don’t miss out and apply for approval with Rocket Mortgage^® today!