What Is Inflation?
Inflation describes a broad, sustained increase in prices across an economy, meaning each unit of currency buys less than it did before. If inflation runs at 3% per year, an item that cost $100 today will cost roughly $103 a year from now.
Economists distinguish demand-pull inflation, where strong spending outpaces the economy's ability to produce, from cost-push inflation, where rising input costs like wages, energy, or raw materials force prices higher. Expectations also matter: if workers and firms expect prices to rise, they raise wages and prices preemptively, which can make inflation self-reinforcing.
How It Is Measured
The most widely cited gauge is the Consumer Price Index (CPI), which tracks the cost of a fixed basket of goods and services over time. The Federal Reserve prefers the Personal Consumption Expenditures (PCE) price index and targets 2% inflation over the long run.
Analysts often focus on core inflation, which excludes volatile food and energy prices, to see the underlying trend. A single hot month matters less than a persistent pattern of readings above or below target.
Example
If the CPI rises from 300 to 309 over twelve months, the inflation rate is (309 - 300) / 300 = 3%. At that pace, prices double in roughly 24 years; at 7% inflation, they double in about 10 years, which is why even moderate inflation compounds into a large loss of purchasing power.
Why It Matters
Inflation is one of the most powerful forces in markets because it drives interest rates. When inflation runs hot, central banks raise rates, which pushes up bond yields, lifts discount rates, and compresses valuation multiples on stocks, especially long-duration growth companies.
Inflation also redistributes wealth: it hurts savers and lenders holding fixed-rate assets while benefiting borrowers who repay debt in cheaper dollars. That is why investors watch every CPI release closely and why real (inflation-adjusted) returns are the true measure of investment performance.
