What Is Inflation?
Inflation is the increase in the prices of goods and services across an economy. When prices inflate, you need more money to buy the same things. The opposite of inflation is deflation, when prices become lower across a range of goods and services. Inflation is an important concept for investors to understand because it eats into the returns on your investments.
How Is the Inflation Rate Calculated?
To measure the inflation rate, you can't just take a single good and measure how its price changes. You have to look at what's called a "basket" of goods and services. In the U.S., inflation rates come from the Consumer Price Index (CPI). The CPI takes what the government considers a representative basket of goods and services, and records changes in their prices from month to month and year to year.
The Inflation Rate Formula
The formula for calculating inflation is as follows:
(Price Index Year 2 - Price Index Year 1) ÷ Price Index Year 1 x 100 = Inflation rate in Year 1
To calculate the inflation rate for a given year, the CPI helps, but it only goes as far back as 1913. If you want to find the historic inflation rate before then, analysts take a current price index and then subtract a comparable price index based on historical data for that year.
As an example, if you’re looking to calculate inflation for the year 1800, analysts would take a current price index and subtract it from a comparable price index based on 1800 data. Then they would divide the number by the 1800 index and multiply by 100 to get a percent.
Historical Inflation Rates
While many countries have battled inflation, and even hyperinflation, in the past 120 years, the U.S. has largely avoided those big increases. The average annual inflation in the U.S. between 1913 and 2019 was 3.10%.
If you look at a table containing the inflation rate from 1915 to 2019, you'll notice deflation (expressed as a negative inflation percentage) during the Great Depression (1929-1939). You'll also notice significant inflation in the '70s and early '80s.
In general, though, the Federal Reserve moderates inflation to keep it around the 2% mark. They do this to maintain inflation rates within a reasonable range.
For reference, the inflation rate from 2017 to 2018 was just 2.44%. However, you should note that inflation rose over 9% in 2022, making it one of the more tumultuous years for inflation in recent decades. The early half of 2023 was still high, but things began to cool off as the year progressed.
Monthly Inflation Rate Timeline for 2023
- November 2023: 3.1% increase
- October 2023: 3.2% increase
- September 2023: 3.7% increase
- August 2023: 3.7% increase
- July 2023: 3.2% increase
- June 2023: 3.0% increase
- May 2023: 4.0% increase
- April 2023: 4.9% increase
- March 2023: 5.0% increase
- February 2023: 6.0% increase
- January 2023: 6.4% increase
How Inflation Impacts Your Bottom Line
If your income stays the same while prices go up, you'll feel the effects of inflation. Your money won't stretch as far and you'll have to make some changes to your budget. In theory, salaries and wages should rise to keep up with inflation so that workers can maintain their standard of living. Social Security benefits, too, are subject to Cost of Living Adjustments (COLAs) that take rising prices into account.
If your income goes up by the same percentage as the inflation rate, your purchasing power is not diminished. It doesn't grow or shrink. If your income rises by a percentage greater than the inflation rate, you'll be able to afford more goods and services. This is the scenario most of us want. It makes us feel better to see our purchasing power growing over time.
Of course, if your income shrinks or disappears, you might be in trouble. Other people who feel the negative effects of inflation are those on a fixed income, or those who hold fixed-income investments while inflation takes its toll on their purchasing power.
For example, if you buy a fixed-income security like a CD with a 5% yield and inflation rises to 7%, you're losing money. In an environment where interest rates are low, it can be tough to beat inflation without buying stocks. Bonds, CDs and savings accounts will keep your principal intact but won't necessarily grow enough to keep pace with inflation. That means you're less likely to meet your retirement savings goals. Fortunately, an inflation calculator can help you figure out a target for your retirement investments in future dollars.
Although stocks bring risk and volatility, they also have a track record of providing inflation-beating returns over time. Investing in stocks not only helps you grow your retirement savings, but it also helps your retirement savings last throughout your entire retirement. It's important to have enough retirement savings that you won't be up all night worrying about inflation.
Once you're retired and out of the workforce, if your retirement nest egg isn't growing, there's not much you can do to preserve your purchasing power if inflation hits. That's why our retirement calculator takes inflation into account when figuring out how much you should save for your golden years.
What Is Real Inflation?
When you see the word "real" used in relation to finance, it means "adjusted for inflation." So if you hear that "real wages" aren't rising, it means that wages aren't rising above inflation. Same with the "real" increase in home prices over time. There's often a big difference between what you see before and after adjusting for inflation.
Another term for “real wages” is “salary adjusted for inflation.” And the terms “money adjusted for inflation” or “dollar value over time” similarly measure the value of a dollar by taking into account the inflation rate over a period of time.
An inflation rate calculator shows you the value of a sum of money at different times in the past and the future. It can tell you about historic prices and future inflation. Estimates of future prices and values are usually based on projections using the average inflation rate, which is essentially an expected inflation calculator.
As we explained earlier, the inflation rate is calculated by taking the average weighted cost of a basket of goods (these include food and energy, among other items and services) in a month and then dividing it by the same basket from a previous month. Note that for dates before 1913, you would take a current price index and subtract it from a comparable price index that is based on data from that earlier date.
Future inflation calculators generally base their projections on recent averages. A future inflation calculator lets you see how many future dollars will equal a certain number of today's dollars. Sometimes you can even adjust the inflation rate to see what would happen to your purchasing power during periods of high inflation or deflation.
Our SmartAsset inflation calculator lets you plot the value of a dollar over time. The chart breaks down the average inflation for a specific range of years and the cumulative inflation over the same period.
Next Steps
If your investments aren't providing returns equal to or greater than the inflation rate, you're probably in trouble. You'll find yourself making tough choices about what you can afford as inflation eats into your purchasing power. Therefore, investors should count on inflation and plan accordingly.
Similarly, when saving for retirement, you should keep an eye on investments that will help you maintain or improve your standard of living. You should consider whether these investments, among other things, can provide inflation-beating gains. The fact that Social Security benefits automatically adjust for inflation is part of what makes them such a powerful resource for retirees.
A financial advisor can help you create a financial plan to protect your portfolio from inflation and interest rate hikes. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
