Every time a dozen eggs or a gallon of gas costs a little more than it did last year, you’re feeling inflation firsthand — so what is inflation, exactly? It’s one of the most talked-about forces in economics, yet the mechanics behind it are often misunderstood. Here’s what inflation actually is, why it happens, and how central banks try to keep it in check.

What Inflation Is, and What It Actually Measures

Inflation is the rate at which prices for goods and services rise across an economy over time, eroding the purchasing power of a currency. In the United States, the two most-watched gauges are the Consumer Price Index (CPI), tracked by the Bureau of Labor Statistics, and the Personal Consumption Expenditures (PCE) price index, which the Federal Reserve prefers as its primary measure. Both track the changing cost of a broad basket of goods and services, from groceries to rent to health care, and report the year-over-year percentage change.

Demand-Pull: Too Much Money Chasing Too Few Goods

One classic driver is demand-pull inflation, which happens when demand across the economy outpaces the supply of goods and services available to meet it. When consumers, businesses, or the government ramp up spending faster than the economy can produce, sellers respond by raising prices. As firms hire more workers to keep up, wages tend to rise too, giving households more money to spend, which can reinforce the cycle further.

Cost-Push: When It Gets More Expensive to Make Things

The other major driver works from the supply side. Cost-push inflation occurs when the price of inputs, such as oil, raw materials, labor, and shipping, rises, and businesses pass those higher costs on to consumers. A spike in oil prices, for instance, raises transportation costs, which in turn nudges up the price of everything from groceries to airline tickets. Natural disasters, supply-chain disruptions, and geopolitical shocks can all trigger this kind of cost-driven price pressure.

Why Expectations Matter Almost as Much as Reality

Economists also point to a subtler cause: what people expect inflation to do next. If businesses anticipate higher costs ahead, they raise prices preemptively. If workers expect their paychecks to buy less next year, they push harder for raises. When expectations stay anchored near a central bank’s target, this dynamic is stable; when they become unanchored, inflation can become self-fulfilling and harder to control.

The Fed’s 2% Target, and Why It’s There

The Federal Reserve has formally targeted 2% annual inflation, measured by the PCE index, since adopting the goal in January 2012. The number isn’t arbitrary: after the runaway inflation of the 1970s and early 1980s, when the rate peaked above 11%, economists concluded that a low, stable, and predictable rate of inflation gives households and businesses confidence to spend, save, and invest without price distortions clouding their decisions. When inflation runs persistently above that target, as it has at various points in recent years, the Fed typically responds by raising interest rates to cool demand and bring price growth back toward its goal.