Lately, everyone seems to be complaining about the same word: inflation. Your family, your friends, the news… even Rebecca from the grocery store. 

We are all well aware of how recent events like the COVID-19 pandemic, stimulus checks, or the war between Russia and Ukraine have all contributed to a concerning increase in inflation.

The problem is that no one has been able to give you a clear explanation of what inflation really means, why it’s so high, and, most importantly, how this affects your financial situation.

But don’t worry. Here is everything you need to know.

What is inflation?

At some point in your life, you’ve probably heard your grandparents say something along the lines of, “Back in my day, you could go to the movie theater for just 69 cents!".

Well, that’s inflation.

The dictionary definition of inflation is pretty straightforward: the rate at which prices for goods and services rise over time.

But let’s put this definition to the test with a real-world example:

It is the beginning of the month. You just got paid, and decide to head down to the grocery store to do your weekly shopping. You load up your cart and head to the cashier. There, Rebecca (your favorite cashier) tells you that it’ll be $100 for everything.

A year later, you decide to go to the grocery store again to purchase the exact same items, but now just carrying a $100 bill.

But when you go to pay, Rebecca tells you that the total is $108, instead of $100. Is Rebecca trying to steal from you? No. Should you choose another cashier as your favorite now? Also, no.

You’ve just experienced the effect of an 8% inflation rate.

How does this work? Is the milk worth more now? Yes and no. The rise in prices doesn’t exactly mean that the products are now worth 8% more, but that the purchasing power of the currency unit you are using (US dollar) has declined by 8%. In a way, your $100 bill is now worth $92 in last year's money.

Fun fact: the US dollar has depreciated by almost 31x since it was first minted in 1792 ($1 from 1792 is equal to $30.92 in 2023).

Now before you move on the the next section, here’s what you need to know.

  • A currency’s value isn’t static. It is under the constant influence of many economical, political, educational, and cultural factors.
  • Inflation will always happen, it is expected.
  • There’s a level (up to 3%) where inflation is not a problem and is believed necessary for the economy to grow.
  • Rebecca has nothing to do with any of this. At least, not on purpose.

Why does inflation happen?

While inflation depends on a lot of the moving parts that make up our global capitalist system, its causes can be grouped into three interconnected categories:

Demand-Pull Inflation: When the demand for goods and services in an economy grows faster than the supply, we’re looking at demand-pull inflation. This makes prices go up because there are too many people competing for the same limited resources.

Cost-push inflation: Cost-push inflation happens when businesses have to raise prices because the cost of production has gone up. This could be the result of increasing wages, higher taxes, or the rising cost of raw materials. When these costs go up, businesses tend to pass them on to customers in order to stay profitable.

Inflation expectations: As mentioned above, inflation is expected and, interestingly, it is also one of the main causes of inflation itself. If enough people think that prices will keep going up in the future (A.K.A: their purchasing power will keep on depreciating), they may ask for pay raises more often to keep their standard of living (which can cause cost-push inflation) or start spending more while their dollar is worth more (which triggers demand-pull inflation).

As a result, all reasons for inflation are interconnected, which makes it quite a complex matter to address. One step in the wrong direction can send a country’s economy out of control very quickly.

So what did we do to prevent an economic downward spiral? The U.S. government created the Federal Reserve System (1913) which protects the country's economy through various market manipulation tactics. How you may ask? Let’s find out.

How does the Federal Reserve control inflation?

The Federal Reserve is the central bank of the United States. Its whole purpose is to protect the economy from crashing by speeding up or slowing down its growth.

The Federal Reserve is in charge of printing money, which means they have total control over cash creation and can define the limits within which private banks can operate.

There are four main ways the Federal Reserve controls inflation:

Open Market Operations (OMO): This is the first line of defense, and it involves the buying and selling of government securities to regulate the supply of money and credit in the economy. When the Fed wants banks to have more money to lend, they buy securities. When they want them to reduce lending supply, it sells these securities, which banks are forced to buy. As a result, banks charge higher interest rates which slow down economic growth and lowers inflation.

Fed Funds Rate (FFR): The FFR is the interest rate that banks charge each other on loans. The Fed can lower, or increase it, to help control how much money is available in the economy, influencing how expensive it is for people or businesses to borrow money. So if the Fed’s interest rate is low, it's cheaper for people or businesses to borrow money, which can help stimulate spending and investment, and vice versa.

Discount Rate: The Fed also adjusts the discount rate. That's the interest rate the Fed charges banks to borrow money from the Fed's discount window.

Managing Expectations: As discussed before, people’s expectations regarding to inflation can make the difference between entering or not a recession. The Fed has the duty to properly manage public expectations in order to keep the economy in order.

Why is inflation so high right now?

The peak of the inflation rate in the U.S. was reported to be 9.1% in June 2022, but many economists estimate that it reached well over double-digits.

The main reason for the interest rate we are experiencing has been the COVID-19 pandemic, but, more importantly, the way in which Trump’s and Biden’s administrations handled its impact.

When COVID hit, the Fed took a very aggressive fiscal and monetary policy, including lowering interest rates and giving out large sums of money through stimulus checks (demand-pull inflation) in order to fight the abrupt increase in shipping costs (cost-push inflation) and layoffs (demand-pull inflation) that the global sanitary emergency had unleashed. In a very short period of time, the government made almost $5 trillion appear from thin air, which solved the problem in the short term, but sentenced inflation to ramp up in the near future.

Another happening that didn’t help the situation was Russia’s invasion of Ukraine, which, among other consequences, abruptly increased the global costs of energy, mainly in the form of gas (cost-push inflation).

What are the feds doing about it?

The Federal Reserve is fighting inflation through increases in interest rates for loans, reaching 4.75% on February 1st, 2023. This is the highest it has been since the 2008 housing bubble.

While high-interest rates slow down growth and make the public struggle in the short term, it has proven to be an effective method to lower inflation. Since its peak in June 2022 (9.1%), inflation rates have now decreased by 2.6 points, reaching 6.5% in December 2022.

How does inflation affects you?

A controlled level of inflation does not have short-term consequences for U.S. citizens. Generally speaking, wages tend to increase with inflation to try and fight the decrease in purchasing power.

The impact of a low level of inflation is mainly visible in your savings on a long-term basis. Just from last year (2022) to this date, if you had $50,000 saved up in the bank, now (2023) it is worth 8% ($4,000) less.

When inflation rates grow abruptly due to unexpected circumstances, they don’t give time for the economy to catch up with wages, and, here, your purchasing power decreases by the minute, often causing people to have to shift their lifestyles. 

As we all have learned in school, lowering the demand will eventually bring down the price of the offer. The Fed’s job is to keep this relationship balanced and healthy to grow the economy safely.

In the meantime, if you are having a difficult time making ends meet, Lever can help you lower interest rates and make payments easier on any loan you might be currently dealing with.