What is Inflation?

Inflation is the steady increase in the average prices of goods and services over time. Inflation reduces a currency’s purchasing power. In an everyday sense, this means that as inflation happens, you ultimately have to spend more to buy products such as a gallon of milk or a tank of gas. Decreasing inflation means you pay less for those products.

Inflation is one of the broadest available measures of current economic performance. Therefore, inflation is an essential tool for investors and policymakers. A government’s central bank relies on inflation data in setting economic and fiscal policy. In the U.S., the central bank is the Federal Reserve System.

Economists often use percentages to represent inflation rates—the inflation rate measures changing prices for goods and services over a specified period. Economists measure inflation over a month, quarter, or a year. A positive inflation rate indicates higher prices for products. For example, the inflation rate for a gallon of milk is 2 percent per year. This year, a gallon of milk costs $3. With a 2 percent inflation rate, next year, a gallon of milk will cost $3.06.

Most economists regard an inflation rate of over 3-4 percent as high inflation. An inflation rate below 0 percent indicates deflation, which suggests a drop in prices. Most developed countries, such as the U.S., target a 2 percent annual inflation rate. Developing economies, such as those in Brazil and India, often aim for 4 percent inflation.

Is Inflation Good or Bad?

A healthy inflation rate is a natural part of a functioning economy. In the U.S., a 2 percent annual inflation rate is a good thing and generally means that the economy is working properly. Prolonged high inflation, deflation, or sudden changes in the inflation rate, however, can shock the economy and lead to recession. The trick is maintaining the right balance.

Inflation’s effects can be positive or negative, depending on your perspective. For consumers, inflation is bad because it means goods and services are more expensive than they were before. Inflation also hurts investors in fixed income securities because their purchasing power decreases as inflation grows.

But some people can benefit from inflation. This includes people with debt, because rising inflation can reduce the cost of their debt. For example, let’s say you have a $50,000 loan at 5 percent interest, and inflation is 10 percent. Inflation reduces your liability by half (5 percent). Another way borrowers can profit from inflation is through rising wages. Increasing inflation can mean higher pay for workers. Still, inflation doesn’t guarantee increased wages. Also, inflation can offset a worker’s higher compensation.

How is Inflation Measured?

In the U.S., there are two primary measurements of inflation. One is the Consumer Price Index (CPI). The CPI measures the average change in prices that consumers pay for goods and services. Included in the CPI are items ranging from food and clothing to electronics and fuel. The Bureau of Labor Statistics (BLS) compiles the CPI each month. The spending habits of 7,000 families living in urban areas in the U.S. comprise the CPI. According to the BLS, about 87 percent of Americans live in urban areas.

Another way to measure inflation is with the Personal Consumption Expenditures (PCE) index. The PCE monitors the change in prices that U.S. consumers pay for goods and services. The Bureau of Economic Analysis compiles the PCE each month.

The PCE is like the CPI, but a critical difference between the two indices is in what each measures. The CPI tracks the prices consumers pay for goods and services. The PCE surveys the costs that businesses sell their products and services for.

Like the CPI, the PCE includes prices for items such as food, clothing, and fuel. But both indexes include what’s called a “core” rate. The core rate excludes food and fuel because prices for these commodities can rapidly change. Often, when policymakers and the media discuss the CPI, the core rate is what they’re referencing.

What Causes Inflation?

There are two leading causes of inflation: demand-pull and cost-push. Demand-pull inflation is the most common cause of inflation. It occurs when demand for a good or service exceeds a producer’s ability to meet that demand. In other words, demand-pull inflation is when demand surpasses supply. The heightened demand for a new electronic device is an example of demand-pull inflation. If the demand outstrips the supply of the device, prices can increase and drive up inflation.

Cost-push inflation is when it becomes more expensive to produce a good or service. Cost-push inflation can occur when the supply of something needed to provide a good or service increases. An example of this type of cost-push inflation is when oil-producing countries decrease their oil production. When they do so, supply of oil decreases. Less supply triggers greater demand, leading to inflation.

Does Inflation Affect Home Prices?

Inflation can impact home prices because inflation affects most goods or services that are in limited supply. And housing is a commodity that’s in limited quantity. As inflation rises, so can home prices, since the cost of providing a house increases.

Plus, inflation can increase the cost of borrowing money to buy a home. A central bank, such as the Federal Reserve, may raise its Federal Funds Rate during periods of high inflation. The move makes a mortgage more expensive because the interest rate on that loan increases. In periods of low inflation, though, loans can become more affordable because interest rates drop.

But a direct correlation between inflation and home prices is not guaranteed. Other factors, such as regional differences, play a role in the cost of buying a home. For example, real estate appreciation often exceeds inflation in urban areas in the U.S. That’s because there’s a higher demand for, but less supply of, land and housing stock in these places. This relationship can drive housing prices higher faster than the rate of inflation.

How Does Inflation Impact Real Estate Investing?

Investors can use housing to benefit from inflation in three ways: value appreciation, increased rents, and debt reduction.

First, inflation increases property values. Housing is an essential human need. And there’s a limited supply of homes. This relationship between supply and demand means home values tend to rise each year. And in the U.S., home prices tend to keep pace with or exceed inflation rates. This means the cost of investing in housing doesn’t exceed the growing value of that investment. For example, you buy a house for $100,000. The home appreciates at 5 percent each year. If there’s 2 percent inflation, the value of your home appreciates more than the cost of that investment.

Another way real estate investors can benefit from inflation is through increased rents. Inflation makes owning a rental property more expensive. But because of inflation, you can increase the rent you charge. Doing so will cover your increased costs. Let’s say you charge $1,000 a month in rent, and inflation is 2 percent per year. Increasing your rent by $20 allows your investment to keep pace with inflation.

Debt reduction is a third way that real estate investors profit from inflation. Inflation depreciates over time the debt owed on a property. For example, if you take out a $100,000 mortgage to buy a house, the value of that debt in the first year of the loan is $100,000. But if inflation is 2 percent every year for 10 years, your debt reduces by $20,000 ($100,000 x 2% x 10 = $20,000).

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