Inflation: causes, history, and what the data shows
Key takeaways
04 · ideas- US average inflation: 3.1% since 1913; post-1990: 2.5%
- Hyperinflation (50%/month+) has occurred 57 times in history
- The 1970s stagflation took 10 years and a deep recession to cure
- At 3% inflation, $100 buys what $74 buys today — in just 10 years
Basic level
The essentials · 1 min
- $100 today → buys what $97 buys next year
- $100 today → buys what $74 buys in 10 years
- $100 today → buys what $54 buys in 20 years
Why does inflation happen?
The simplest explanation: too much money chasing too few goods.
Three main causes:- Demand-pull: Economy grows fast, people spend more, prices rise
- Cost-push: Production costs rise (oil prices, wages), companies pass on the cost
- Monetary: Central banks create money faster than economic growth supports
Small, predictable inflation (2%) is considered healthy — it encourages spending over hoarding, makes debt easier to service, and gives central banks room to cut rates in recessions.
Intermediate level
How it applies · 2 min
Historical inflation in the United States
| Decade | Average annual inflation |
|---|---|
| 1920s | −2.2% (deflation) |
| 1940s | +5.4% (WWII spending) |
| 1950s | +2.1% |
| 1960s | +2.5% |
| 1970s | +7.1% (oil crisis + policy mistakes) |
| 1980s | +5.8% (disinflation) |
| 1990s | +3.0% |
| 2000s | +2.6% |
| 2010s | +1.8% |
| 2020s | +5.5% (to date; 2020–2023 average) |
The 1970s stand out: oil shocks + expansionary monetary policy + wage-price spirals created a decade of damaging inflation. The Fed, under Paul Volcker, broke it in 1981 by raising rates to 20% — causing the deepest recession since the 1930s.
What inflation does to assets
| Asset | Inflation hedge quality |
|---|---|
| Cash | ❌ Loses purchasing power directly |
| Short-term bonds | ⚠️ Limited — returns often < inflation |
| Long-term bonds | ❌ Worst — fixed payments worth less |
| Stocks | ✅ Long-term real returns ~7% above inflation |
| Real estate | ✅ Property values and rents typically track inflation |
| TIPS | ✅ Treasury Inflation-Protected Securities — real return tied to inflation (historically) |
| Gold | ⚠️ Mixed — good in some periods, poor in others |
| Bitcoin | ❓ Too short a history to evaluate |
TIPS: the only inflation hedge tied to CPI
Treasury Inflation-Protected Securities adjust their principal with CPI. If you buy $10,000 in TIPS at 0.5% real yield:- Year 1 CPI up 4%: principal becomes $10,400, interest = $52
- Year 2 CPI up 3%: principal becomes $10,712, interest = $53.56
You're guaranteed a real return of 0.5% above inflation. The downside: during deflationary periods, TIPS don't fall below par at maturity — protection exists even in deflation.
Advanced level
The math, step by step · 1 min
The Fisher equation and real returns
The Fisher equation relates nominal returns, real returns, and inflation:
For small values: r_{real} \approx r_{nominal} - \pi
If a 10-year Treasury bond yields 4.5% and expected inflation is 2.5%, the real yield is ~2.0%.
The break-even inflation rate: The difference between nominal Treasury yield and TIPS yield for the same maturity.
If 10yr Treasury = 4.5% and 10yr TIPS = 2.0%, break-even inflation = 2.5%. The market implies inflation of 2.5% over the next 10 years. If you expect higher inflation, TIPS are better; if lower, nominal Treasuries win.
Inflation's compounding effect
The real value of a nominal cash flow C received in year t with inflation \pi:
For a retiree expecting $50,000/year in Social Security (COLA-adjusted) and $30,000 in fixed pension:
At 3% inflation, year 10:- SS ($50,000 × COLA): retains real value = $50,000 real
- Pension (fixed $30,000): real value = $30,000/(1.03^{10}) = $22,320
The pension loses 26% of its purchasing power. Over 20 years: $30,000 nominal = $16,619 real. This is the single most important reason to favor inflation-indexed income in retirement.