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What Is Inflation?

Matt D'Angelo
Matt D'Angelo

Inflation and how it impacts the wider economy is important to your business.

As a small business owner, you need to understand inflation and how it impacts your company. "Inflation" is a buzzword that most people have heard but few really understand. You might know that inflation has much to do with the price of goods and services, but you're not quite sure how they are related. Why does inflation occur, where does it come from, and why does inflation matter to small businesses?

What is inflation?

Put simply, inflation is the rate at which the cost of goods and services rises over time. It could also be thought of as a reduction in the value of a dollar, because consumers are now able to purchase less than they previously could with the same dollar bill. 

While the annual rate of inflation fluctuates each year, from 1913 to 2013 the U.S. experienced an average inflationary rate of 3.22%. That means, on average, something that costs $100 this year would cost $103.22 next year. 

Inflation is calculated by the Bureau of Labor Statistics using several economic indexes, including the Consumer Price Index (CPI) and the Producer Price Indexes (PPI). The CPI measures price changes from the perspective of the consumer, and tracks price changes in various goods and services. The PPI looks at price changes from the sellers' perspective by measuring the prices that companies pay for the raw materials that are used to produce goods. The PPI is useful, because inflation often begins in the supply chain when the cost of component parts goes up, for example. Manufacturers then charge more for their finished products. 

The Federal Reserve actively works to maintain an inflation rate near 2%. When the rate gets significantly higher than the 2% target, the Federal Reserve can take several actions to try and slow economic growth, including raising interest rates. 

While many people may think that all inflation is bad, economists argue that some controlled inflation is good for an economy. Inflation encourages spending, because when dollars are losing value, it provides a disincentive to save those dollars. Inflation also provides companies with the confidence to hire new employees. Inflation only becomes dangerous when it is uncontrolled and unexpected, increasing prices quickly to the point it grinds all spending (and, therefore, economic activity) to a halt. 

The economy doesn't necessarily experience inflation every year. The opposite of inflation, deflation, is when prices go down, and the inflation rate falls below 0%. While you might think, "Oh boy, lower prices," deflation is not usually a welcome thing. An indicator that economic conditions are deteriorating, deflation often results in lower levels of production and, ultimately, high rates of unemployment.

Types of inflation

There are two main types of inflation: demand pull and cost push. Fueled by income and strong consumer demand, demand-pull inflation occurs when the economy demands more goods and services than are available. If demand skyrockets but supply, or the overall amount of goods and services, remains the same, the demand pulls the prices for things up. 

Imagine you own a bagel shop in your local town. If your community is doing well financially and people love your bagels, the demand for them will increase. If you can't produce any more bagels because you don't have enough ovens, the amount of bagels you can sell remains the same. But people want more of them, thus the value of your bagels increases, and so can your price. This is a very simple example. Demand-pull inflation occurs on a grand scale across an entire economy. 

Cost-push inflation happens when the demand for goods increases because production costs rise to the point where fewer goods can be produced. As demand remains the same but the cost of supply increases, the price is pushed upward by supply costs. In the context of the bagel store, imagine if people love your bagels and want to buy them, but a law has changed where you have to pay higher wages to your workers. Higher wages means it costs more for you to produce each bagel, which means you'll have to push prices higher to cover your costs. 

These are the two basic types of inflation. Inflation can combine, however, with other market forces to create an entirely new economic phenomenon. Other types of inflation include hyperinflation, a rapid and out-of-control form of inflation; pricing power inflation, which occurs when businesses raise prices to increase profits; sectoral inflation, which is when the rising prices are confined to just one industry; and stagflation, which occurs when inflation is rising despite slow economic growth.

History of inflation

While the inflation rate has ranged from 1.5 and 3.5% for the past two decades, it has fluctuated a great deal in the years before. While inflation rates have only been tracked officially for the past 100 years, it played a significant role in the economy in the years well before that. 

Between 1775 and 1865, inflation was blamed for two U.S. currency collapses: the Continental currency during the Revolutionary War and Confederation notes during the Civil War. In the last century, inflation rates have spiked to 18% in 1918, 15.6% in 1920 and 14.4% in 1947. Inflation in the United States has only risen above 10% twice since 1980. It topped out at 13.5% in 1980, and a year later, it reached 10.3%. 

Since the financial crisis in 2008, inflation has remained below 2.5% every year. The Federal Reserve aims to remain a target rate of 2% inflation annually, and now that the economy is stable and growing at a gradual but healthy rate, the Fed is slowly hiking interest rates in a bid to manage anticipated inflation. 

As an entrepreneur, you should plan and strategize for inflation before it arrives. In a largely recovered economy, now is the time to lay those plans.

How does inflation affect interest rates?

Inflation is an important concept for small business because it affects interest rates, which impacts how much it costs to borrow money. At the heart of the relationship between inflation and interest rates are real and nominal interest rates. Nominal interest rates are the interest rates advertised by your bank. They are, for example, the interest accrued on your savings in your savings account. The real interest rate is the nominal interest rate adjusted for inflation. 

In an economic scenario where there is 3% inflation and you have a variable rate interest loan at 10% interest that's adjusted for inflation, the real interest rate you will pay is 13%. In other words, inflation can end up costing you more money. 

This is one way interest is impacted by inflation. The other is inflation can impact the federal funds rate. This rate, determined by the Federal Reserve Bank, is the basis for loans throughout the United States. When the federal funds rate is low, interest rates are low and borrowing money costs less, which drives up inflation. When the federal funds rate is high, interest rates are high and it's more expensive to borrow money, which is a measure that can help curb inflation.

How does the Federal Reserve Bank stop inflation?

The Federal Reserve Bank influences the economy through several measures, one of which is the federal funds rate. The fed funds rate has a direct impact on inflation. As described above, it serves as the basis for all loans throughout the United States. It is, essentially, the market value for money within the economy at any given time. If the Fed raises the fed funds rate, money is more expensive to borrow and fewer people will be inclined to take out loans, thus lowering inflation. When the fed funds rate is low, borrowing money is inexpensive and consumers are incentivized by the low price to take out loans. 

This is the basic way that the Federal Reserve Bank controls inflation. There are several other scenarios where the Fed can control inflation and economic activity in the United States, as with quantitative easing during the financial crisis of 2008. As a small business owner, it's imperative to be aware of market forces as you take out loans and conduct business operations. This means tuning into financial news about the Federal Reserve and fed funds rate activity.

How can you protect your business from inflation?

Inflation is a market force that you cannot control, so it's important to have both proactive and reactive strategies to inflation. This all starts with staying informed: If the fed funds rate is low, it's a good time to take out a loan. If it's high, it may be better to wait until it comes down. 

If inflation is coming and experts are expecting prices of goods to rise, there are a few strategies you can implement to protect your business. The main goal, however, should be to free up as much capital as possible to weather increasing prices. 

  • Reduce debt. You'll need more cash on hand to deal with the rising costs of inflation. If you can consolidate debt or pay off creditors before a spike in inflation, you can remain financially flexible.

  • Optimize business efficiency. Consolidate departments, rethink business processes, adjust expectations, and do your best to stay lean.

  • Rethink your suppliers. Consider who you're working with on the supply side of your business, and do your best to cut costs where possible. 

Adam C. Uzialko and Chad Brooks contributed to the reporting and writing in this article.

Image Credit: Poike / Getty Images
Matt D'Angelo
Matt D'Angelo,
Business News Daily Writer
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I'm a staff writer for Business.com and Business News Daily. I cover various small business topics, including technology, financing and marketing.