What is inflation?

Published Thursday 23 July 2026

Table of contents

• What is inflation?
• What causes inflation?
• How is inflation measured?
• What is the current US inflation rate?
• How inflation affects small businesses
• How small businesses can manage inflation
• The role of the Federal Reserve
• Keep your finances organized with Xero
• FAQs on inflation

Key takeaways

• Inflation is the rate at which prices rise over time, reducing the purchasing power of your money. It's driven by demand-pull, cost-push, and built-in factors.
• The Consumer Price Index (CPI), published by the Bureau of Labor Statistics, is the most commonly cited measure of inflation in the US.
• Small businesses often feel inflation's impact more acutely than larger companies, facing rising supplier costs, tighter margins, and higher borrowing expenses.
• You can protect your business by monitoring margins closely, adjusting pricing strategically, managing cash flow, and cutting unnecessary expenses.

What is inflation?

Inflation is the rate at which prices for goods and services increase over time, reducing the purchasing power of money. When inflation rises, each dollar you earn buys less than it did before.

Inflation results from the interplay between supply, demand, and the money supply in the economy. When demand for goods outpaces supply, or when the cost of producing goods rises, prices tend to climb. Central banks also influence inflation by adjusting how much money circulates in the economy.

Some inflation is normal in a healthy economy. Most economists consider a moderate, steady rate of inflation a sign of growth. But when prices rise too quickly, it creates real challenges for consumers and businesses alike.

What causes inflation?

Economists generally point to 3 main types of inflation, each driven by different forces in the economy.

• Demand-pull inflation: this happens when demand for goods and services exceeds supply. When consumers and businesses compete for limited products, sellers can charge higher prices. Government stimulus spending and low interest rates can contribute to demand-pull inflation.
• Cost-push inflation: this occurs when the cost of producing goods rises, and businesses pass those higher costs on to customers. Rising raw material prices, supply chain disruptions, and higher wages can all trigger cost-push inflation.
• Built-in inflation: sometimes called the wage-price spiral, this develops when workers expect prices to keep rising and demand higher wages to keep up. Businesses then raise prices to cover the increased labor costs, creating a self-reinforcing cycle.

In practice, these 3 types often overlap. A supply shock can raise production costs (cost-push) while also reducing availability and driving up demand for remaining goods (demand-pull).

How is inflation measured?

Several indexes track price changes across the economy. Each one measures a slightly different basket of goods and services, giving policymakers and businesses different views of inflationary trends.

• Consumer Price Index (CPI): published monthly by the Bureau of Labor Statistics (BLS), the CPI tracks the average change in prices paid by urban consumers for a basket of everyday goods and services. It's the most widely cited inflation measure in the US and covers categories like food, housing, transportation, and medical care.
• Personal Consumption Expenditures (PCE) Price Index: published by the Bureau of Economic Analysis, the PCE index measures price changes across a broader range of consumer spending. The Federal Reserve prefers the PCE index for setting monetary policy because it adjusts more quickly when consumers shift their spending patterns.
• Producer Price Index (PPI): also published by the BLS, the PPI measures price changes from the seller's perspective. It tracks what producers receive for their goods and services, making it a useful leading indicator of future consumer price changes.

The basic formula for calculating the inflation rate between 2 periods is: ((Price in Current Period - Price in Previous Period) / Price in Previous Period) x 100. For example, if a basket of goods cost $100 last year and costs $103.50 this year, the inflation rate is 3.5%.

What is the current US inflation rate?

The CPI is the most commonly cited measure of inflation in the US, and the Bureau of Labor Statistics publishes updated figures monthly. You can check the latest data directly on the BLS website for the most current rate.

Keep in mind that headline CPI includes volatile categories like food and energy. Core CPI, which strips out those categories, gives a clearer picture of underlying price trends. Both figures matter when you're planning your business budget and pricing strategy.

How inflation affects small businesses

Inflation doesn't affect all businesses equally. Depending on your industry, pricing flexibility, and financial position, rising prices can create both challenges and, in some cases, limited benefits.

Positive effects

In certain situations, inflation can work in your favor. The cash value of assets like property, equipment, and inventory tends to rise with inflation. If you hold fixed-rate debt, inflation effectively reduces the real value of what you owe, because you're repaying with dollars that are worth less than when you borrowed them.

Negative effects

For most small businesses, inflation creates more problems than advantages. According to Xero Small Business Insights, US small business sales growth averaged just 2.4% year-over-year in 2025, less than half the long-term average of 5.5%. At the same time, nominal US GDP averaged 5.1% growth, highlighting a significant gap between headline economic figures and the reality small business owners face.

• Rising supplier costs squeeze your profit margins, and it may be difficult to pass those increases along to customers without losing business.
• Your customers' purchasing power drops, which means they tend to cut back on nonessential spending first. Businesses that sell discretionary goods or services often feel this shift quickly.
• Borrowing becomes more expensive as central banks raise interest rates to combat inflation. For example, the Federal Reserve held its target rate at 3.5%–3.75% as of early 2026, with inflation remaining somewhat elevated despite rate cuts in late 2025.

How small businesses can manage inflation

You can't control inflation, but you can take practical steps to reduce its impact on your business. Here are strategies that help small business owners stay ahead of rising costs.

• Cut unnecessary expenses: review your spending regularly and look for cost savings. Switch to lower-cost suppliers, renegotiate leases, and reduce discretionary spending where possible.
• Monitor your margins closely: track how inflation affects your costs versus your revenue. If your margins are shrinking, you'll want to act before profitability is at risk.
• Adjust pricing strategically: raise prices in small, regular increments rather than one large increase. Offer loyal customers flexible payment terms to soften the impact.
• Manage cash flow carefully: credit tends to be more expensive during inflationary periods, so focus on managing cash flow and maintaining liquidity. If you need to borrow, shop around for the best terms.
• Build a small business budget that accounts for rising costs: factor expected price increases into your forecasts so you're not caught off guard.
• Consider inflation hedges: diversifying your revenue streams and investing in assets that tend to hold value during inflationary periods can provide a buffer. Focus on recession-proofing your business to build resilience against economic uncertainty.

The role of the Federal Reserve

The Federal Reserve (the Fed) is the central bank of the United States, and controlling inflation is one of its primary responsibilities. The Fed targets an annual inflation rate of 2%, which it considers consistent with a healthy, growing economy.

The Fed's main tool for managing inflation is the federal funds rate, the interest rate at which banks lend to each other overnight. When inflation rises above the 2% target, the Fed raises interest rates to make borrowing more expensive, which slows spending and reduces upward pressure on prices. When inflation falls too low, the Fed may cut rates to encourage borrowing and spending.

Beyond interest rates, the Fed uses open market operations (buying and selling government securities) and reserve requirements to influence the money supply. These tools work together to keep inflation within a range that supports economic stability without eroding purchasing power too quickly.

Keep your finances organized with Xero

Staying on top of your finances is especially important when prices are rising. Accurate, up-to-date records help you spot cost increases early, make informed pricing decisions, and keep cash flow under control.

Xero's cloud accounting software brings your finances together in one place, with automated bank feeds, invoicing, and real-time reporting that help you track expenses and margins as they change. Get one month free.

FAQs on inflation

Here are answers to frequently asked questions about inflation.

What is a simple definition of inflation?

Inflation is the gradual increase in prices across an economy over time. As prices rise, each unit of currency buys fewer goods and services than it did before.

What causes inflation?

Inflation is caused by an imbalance between supply and demand, rising production costs, or an increase in the money supply. Government spending, supply chain disruptions, and wage growth can all contribute.

How does inflation affect small businesses?

Small businesses face higher costs for supplies, rent, and labor, while their customers may cut back on spending. This combination can compress margins and make it harder to maintain profitability.

Is some inflation good for the economy?

Most economists consider moderate inflation (around 2% per year) a sign of a growing economy. It encourages spending and investment, because holding cash loses value over time.

What is the difference between inflation and deflation?

Inflation is a sustained rise in the general price level, while deflation is a sustained decline. Deflation can discourage spending (consumers wait for lower prices) and increase the real burden of debt, which is why central banks typically aim to avoid it.