Full answer
Inflation means each dollar buys less over time. If inflation is 3% per year, a $100 grocery bill becomes $103 next year for the same items. Over 20 years at 3%, $100 of purchasing power requires $181. This is why savings sitting in a low-interest account lose real value — if the account earns 0.5% and inflation is 3%, you're losing 2.5% in purchasing power annually.
What causes inflation? Too many dollars chasing too few goods. Causes include: increased money supply (central bank expanding the money supply), demand surges (post-COVID stimulus spending), supply chain disruptions (reducing available goods), rising energy prices (which raises costs throughout the economy), and wage increases that exceed productivity growth.
The Federal Reserve's primary tool to fight inflation is raising interest rates. Higher rates make borrowing more expensive, slowing spending and investment — less money chasing goods. The 2022–2023 rate hiking cycle raised the federal funds rate from near 0% to 5.25–5.50%, the fastest pace in 40 years, in response to inflation reaching 9.1% in June 2022.
Different inflation measures serve different purposes. CPI (Consumer Price Index) measures a fixed basket of consumer goods — rent, food, transportation, healthcare. PCE (Personal Consumption Expenditures) is the Fed's preferred measure — it adjusts the basket dynamically as consumers substitute goods. Core inflation strips out food and energy (which are volatile) to show the underlying trend.
For individuals, inflation affects different people very differently based on what they own and owe. Homeowners with fixed-rate mortgages benefit — they're paying back cheaper future dollars. Renters and people with variable-rate debt are hurt. Savers in low-yield accounts lose. Stockholders and real estate holders are somewhat protected since asset prices tend to rise with inflation. I-Bonds and TIPS (Treasury Inflation-Protected Securities) are specific instruments designed to preserve purchasing power.