A Closer Look at Inflation: What It Is, How It’s Measured, and Why It Matters

Inflation is both incredibly tangible—it can affect everything from your grocery bill to your income—and incredibly abstract. A buzzword thrown around by politicians, economists, and dinner party guests. So what is inflation, really? And how does it impact your life?

In this article, we deep dive into what inflation is and how it might impact your finances, with a specific focus on retirement, as well as inflation’s effect on the overall economy.

What Is Inflation?

Inflation is the rate at which prices change over time. For example, if milk cost $3.75 per gallon last year and is now $4.25, that’s a 13.3% price increase. In other words, the annual inflation for that gallon of milk is 13.3%.

A certain amount of inflation is normal in a growing economy—we expect a gallon of milk to cost more now than it did 30 years ago. The U.S. averages 2-3% inflation each year.

That 2-3% number is based on the Consumer Price Index (CPI), which is how the U.S. Bureau of Labor Statistics tracks inflation. CPI tracks the price of a “basket of consumer goods and services”—things like cars, cosmetics, and gallons of milk.

The government bases the basket on actual goods urban consumers report buying, so there’s a lag between when they survey consumers, and when data is published. For this reason, the CPI can be a confusing economic indicator and may not reflect what you’re experiencing at home. For instance, many Americans experienced higher prices at the grocery store in 2021, but inflation CPI didn’t indicate above-average inflation until 2022.

Some critics say that CPI isn’t an accurate reflection of inflation because it’s too narrow in scope. For instance, it tracks prices paid by urban consumers, specifically. It also ignores some major expenses, like health care and housing. (Out-of-pocket medical expenses are tracked, but health insurance premiums are not.) If your buying habits are different than those consumers surveyed, the percent changes are much less relevant to your personal financial standing.

Additionally, economists and investors tend to watch inflation closely when it’s high, which adds a layer of complexity. For example, inflation might decrease from 6% one month to 5% the next. That’s good for the economy overall, but prices are still 5% higher than they were a year ago. While headlines may highlight lower inflation, in absolute dollars, inflation may still feel very real.

Why Does Inflation Matter?

Simply put, inflation tracks how much a dollar can buy. Say the price of something goes from $1 today to $2 next year. Your money has less power when it comes to purchasing that item. When we talk about inflation risk, we’re referring to this loss in “purchase power.”

Inflation risk is particularly important to retirees or anyone living on a fixed income. If you only have $1, and the price increases to $2, you won’t be able to afford the item. For Bogart Wealth clients in or nearing retirement, we track inflation numbers closely to help manage this risk.

Retirees may need to adjust their withdrawal strategy to cover increasing expenses. However, increased withdrawals should be considered alongside other factors, including lifestyle, market conditions, and additional sources of income.

Social Security, for example, adjusts for inflation each year. The Social Security Administration’s cost of living adjustment (or COLA) is tied to CPI, another reason that the metric is so important. Some pension plans offer COLAs as well, though electing inflation-adjusted benefits may impact the terms and amount of your lifetime payments.

It’s not just inflation that matters, though. The response to inflation matters as well.

Inflation and the Economy

When inflation does rise rapidly, as it did in 2022, it’s one of the primary jobs of the U.S. Central Bank to keep it in check. Over the last year or so, you’ve probably heard of inflation discussed in the context of the Federal Reserve, or “Fed,” and monetary policy. The Fed targets 2-3% annual inflation. For context, inflation in 2019 and 2020 stayed below 2%. In 2022, it averaged 8%.

To combat high inflation, the Fed’s first response is usually to rase rates. Higher interest rates have a domino effect across the economy. In addition to stemming inflation, higher rates can also impact the stock market, bond market, mortgage rates, and more. They can even impact hiring. The Fed knows this and tries to raise rates strategically to prevent the kind of negative economic side effects that could result in a recession.

While higher rates pose one risk to the economy, high inflation poses another. When consumers lose purchasing power, they tend to buy less. This can lead to economic stagnation. Stagflation refers to this combination of high inflation and a stagnant economy. (The term was coined by a British politician in the 1960s.) It can also be indicated by high unemployment, and it’s worrisome when it happens because, if prices are increasing but the economy is stagnant, people may not be able to afford those higher prices.

Of course, prices don’t always go up. The opposite can happen. If something costs $1 and 50 cents in a year, there’s been a 50% deflation in price.

Deflation can occur for a few reasons. On the positive side, if technology improves and productivity increases, prices may fall. However, when prices fall at scale (versus for a single product or industry), it’s most often linked to falling demand. Basic market economics say that if the supply of something remains constant, and demand falls, prices come down to meet the lower demand.

We tend to see deflation during periods of recession. As a point of reference, consumer prices in the U.S. fell 0.4% in the wake of the 2007 Financial Crisis.

If you have questions about our outlook for inflation, or how we factor inflation into investing and planning decisions, we can discuss at our next client meeting.

Sources: Bureau of Labor Statistics, Minneapolis Federal Reserve, CME Group, Investopedia, Merriam-Webster, The Library of Economics and Liberty, The Borgen Project

Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Bogart Wealth, LLC [“Bogart Wealth”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level (s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Bogart Wealth. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Bogart Wealth is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Bogart Wealth’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at bogartwealth.com

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