This dollar doesn't go as far as it used to because... inflation.
Sarah Tew/CNETWhether it's milk at the grocery store, airplane tickets or car rentals, prices are on the rise. In May, the Consumer Price Index for US goods and services climbed more than 5% from a year earlier -- its sharpest increase since the US housing market crashed more than a decade ago.
That's not the same kind of dramatic rise in prices we saw at the beginning of the pandemic, when consumers were panic-buying toilet paper and hand sanitizer. Rather, the May increase may be a signal that we're entering a period of inflation -- a sustained rise in the cost of living -- likely brought on by the gradual reboot of the economy following its abrupt shutdown in March 2020.
Inflation isn't inherently good or bad. Kept in check, it's the sign of a healthy economy. It keeps us spending rather than tucking our cash under a mattress. But while inflation rates have remained steady in recent decades, some worry current prices will keep climbing to the point where consumers are squeezed, undermining the economic recovery.
Here are five key things you need to know about inflation and whether to start worrying about it.
What is inflation?
Simply put, inflation is a sustained increase in consumer prices. It means a dollar bill doesn't get you as much as it did before, whether you're at the grocery store or a used car lot.
Inflation is usually caused by either increased demand -- such as COVID-wary consumers finally ready to leave their homes and spend money -- or supply-side factors like increases in production costs.
Inflation is a given over the long term, and it requires some historical context to mean anything.
For example, in 1985, the cost of a movie ticket was $3.55. Today, watching a film in the theater will easily cost you $13 for the ticket alone -- never mind the popcorn, candy or soda. A $20 bill in 1985 would buy you almost four times what it buys today.
Over the past century, there have only been a few years when the annual inflation rate in the US has been a negative number. But we also measure inflation in the short term, where we can see sharper rises, such as the one we saw for April.
How do we know if we're in a period of inflation?
Inflation isn't a physical phenomenon we can observe. It's an idea that's backed by a consensus of experts who rely on market indexes and research.
One of the most closely watched gauges of inflation is the Consumer Price Index, which is produced by the federal Bureau of Labor Statistics and based on the diaries of urban shoppers. CPI reports track data on 80,000 products including food, education, energy, medical care and fuel.
The BLS also puts together a Producer Price Index, which tracks inflation more from the perspective of the producers of consumer goods. The PPI measures changes in seller prices reported by industries like manufacturing, agriculture, construction, natural gas and electricity.
And there's also the Personal Consumption Expenditures price index, prepared by the Bureau of Economic Analysis, which tends to be a broader measure because it includes all goods and services consumed, whether they are bought by consumers, employers or federal programs on consumers' behalf.
In May, the Labor Department announced that the CPI increased by 5% in May, following an increase of 4.2% in April -- the rise that first caused a stir among market watchers. Some specific market segments are experiencing even more dramatic price surges: The index for used cars and trucks shot up 10% in April.
But that rise in the CPI, in and of itself, doesn't mean we're necessarily in a cycle of rising inflation. That's where the Federal Reserve comes in.
How the Federal Reserve can fix things
The Fed, created in 1913, is the control center for the US banking system and handles the country's monetary policy. It's run by a board of governors and is also made up of a Federal Open Market Committee, 12 regional Federal Reserve banks and 24 branches.
While the BLS reports on inflation, the Fed moderates inflation and employment rates by managing the supply of money and setting interest rates. Part of its mission is to keep average inflation at a steady 2% rate; it's a delicate balancing act, and the main lever it can pull is to adjust interest rates. In general, when interest rates are low, the economy and inflation grow. And when interest rates are high, the economy and inflation slow.
The Fed considers recent rises in inflation to be "transitory" and credits "strengthened" economic activity and employment rates to coronavirus vaccinations and related policies. In April, Federal Reserve Vice Chairman Richard Clarida said prices "are likely to rise somewhat further before moderating later this year" and warned that they might even exceed its 2% rate goal. But he called them "one-time increases."
"I expect inflation to return to -- or perhaps run somewhat above -- our 2% longer-run goal in 2022 and 2023," Clarida said in a speech in May.
What about the other 'flations': Deflation, hyperinflation, stagflation?
There are a few other "flations" worth knowing about. Let's brush up.
Deflation
As the name infers, deflation is the opposite of inflation. Economic deflation is when the cost of living goes down. (We saw this, for example, during parts of 2020.) Widespread deflation can have a devastating impact on an economy. Throughout US history, deflation tends to accompany economic crises. Deflation can portend an oncoming recession as consumers tend to halt buying in hopes that prices will continue to fall, thus creating a drop in demand. Eventually, this leads to consumers spending even less, lower wages and higher unemployment rates.
Hyperinflation
This economic cycle is similar to inflation in that it involves an increase in the cost of living. However, unlike inflation, hyperinflation takes place rapidly and is out of control. Many economists define hyperinflation as the increase in prices by 1,000% per year. Hyperinflation is uncommon in developed countries like the US. But remember Venezuela's economic collapse in 2018? That was due in part to the country's inflation rate hitting more than 1 million percent.
Stagflation
Stagflation is when the economy enters a period of stagnation. In these instances, unemployment is high, prices are rising and economic growth is slow. Stagflation was first recognized in the 1970s after the energy crisis. Simultaneously, inflation doubled, the US experienced negative GDP growth and unemployment reached 9%. Memories of this dark economic time factor into current fears of inflation spiraling out of control, even though the circumstances are very different.
Should we be worried?
No -- not yet anyway. While you're seeing the cost of day-to-day living go up, it's likely just the normal and expected response to the stalled-out pandemic economy. There's been no consensus among experts that inflation will become a sustained cycle. It's just on their radar, particularly as Capital Hill is weighing some ginormous economic stimulus packages and the economy is making a comeback.
But take comfort in the fact that the Fed has had our backs, of late anyway; the economy has consistently run at or below its inflation target of 2% for almost a decade. So let the Fed do the worrying (about inflation anyway) for you. That's its job.
Michelle Meyers and Justin Jaffe contributed to this report.
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