McKinsey Explainers
What is inflation?
Inflation is the gradual loss of purchasing power, reflected in a
broad rise in prices for goods and services.
April 2024
Inflation has been top of mind for many over the
past few years. But how long will it persist? In June
2022, inflation in the United States jumped to 9.1
percent, reaching the highest level since February
1982. The inflation rate has since slowed in the
United States, as well as in Europe, Japan, and the
United Kingdom, particularly in the final months of
2023. But even though global inflation is higher
than it was before the COVID-19 pandemic, when it
hovered around 2 percent, it’s receding to historical
levels. In fact, by late 2022, investors were
predicting that long-term inflation would settle
around a modest 2.5 percent. That’s a far cry from
fears that long-term inflation would mimic trends of
the 1970s and early 1980s—when inflation
exceeded 10 percent.
Inflation refers to a broad rise in the prices of goods
and services across the economy over time, eroding
purchasing power for both consumers and
businesses. Economic theory and practice, observed
for many years and across many countries, shows
that long-lasting periods of inflation are caused in
large part by what’s known as an easy monetary
policy. In other words, when a country’s central
bank sets the interest rate too low or increases
money growth too rapidly, inflation goes up. As a
result, your dollar (or whatever currency you use)
will not go as far today as it did yesterday. For
example: in 1970, the average cup of coffee in the
United States cost 25 cents; by 2019, it had
climbed to $1.59. So for $5, you would have been
able to buy about three cups of coffee in 2019,
versus 20 cups in 1970. That’s inflation, and it isn’t
limited to price spikes for any single item or
service; it refers to increases in prices across a
sector, such as retail or automotive—and,
ultimately, a country’s economy.
How does inflation affect your daily life? You’ve
probably seen high rates of inflation reflected in
your bills—from groceries to utilities to even higher
mortgage payments. Executives and corporate
leaders have had to reckon with the effects of
inflation too, figuring out how to protect margins
while paying more for raw materials.
But inflation isn’t all bad. In a healthy economy,
annual inflation is typically in the range of two
percentage points, which is what economists
consider a sign of pricing stability. When inflation is
in this range, it can have positive effects: it can
stimulate spending and thus spur demand and
productivity when the economy is slowing down
and needs a boost. But when inflation begins to
surpass wage growth, it can be a warning sign of a
struggling economy.
Inflation may be declining in many markets, but
there’s still uncertainty ahead: without a significant
surge in productivity, Western economies may be
headed for a period of sustained inflation or major
economic reset, as Japan has experienced in the
first decades of the 21st century.
What does seem to be changing are leaders’
attitudes. According to the 2023 year-end
McKinsey Global Survey on economic conditions,
respondents reported less fear about inflation as a
risk to global and domestic economic growth. But
this sentiment varies significantly by region:
European respondents were most concerned about
the effects of inflation, whereas respondents in
North America offered brighter views.
What causes inflation?
Monetary policy is a critical driver of inflation over
the long term. The current high rate of inflation
is a result of increased money supply, high raw
materials costs, labor mismatches, and supply
disruptions—exacerbated by geopolitical conflict.
What is inflation?
2
In general, there are two primary types, or causes,
of short-term inflation:
— Demand-pull inflation occurs when the demand
for goods and services in the economy exceeds
the economy’s ability to produce them. For
example, when demand for new cars recovered
more quickly than anticipated from its sharp
dip at the beginning of the COVID-19 pandemic,
an intervening shortage in the supply of
semiconductors made it hard for the automotive
industry to keep up with this renewed demand.
The subsequent shortage of new vehicles
resulted in a spike in prices for new and
used cars.
— Cost-push inflation occurs when the rising price
of input goods and services increases the price
of final goods and services. For example,
commodity prices spiked sharply during the
pandemic as a result of radical shifts in demand,
buying patterns, cost to serve, and perceived
value across sectors and value chains. To offset
inflation and minimize impact on financial
performance, industrial companies were forced
to increase prices for end consumers.
Learn more about McKinsey’s Growth, Marketing &
Sales Practice.
The period from the mid-1960s through the early
1980s in the United States, sometimes called the
“Great Inflation,” saw some of the country’s highest
rates of inflation, with a peak of 14.8 percent in
1980. To combat this inflation, the Federal Reserve
raised interest rates to nearly 20 percent. Some
economists attribute this episode partially to
monetary policy mistakes rather than to other
causes, such as high oil prices. The Great Inflation
signaled the need for public trust in the Federal
Reserve’s ability to lessen inflationary pressures.
Inflation isn’t solely a modern-day phenomenon, of
course. One very early example of inflation comes
from Roman times, from around 200 to 300 CE.
Roman leaders were struggling to fund an army big
enough to deal with attackers from multiple fronts.
To help, they watered down the silver in their
coinage, causing the value of money to slowly fall—
and inflation to pick up. This led merchants to raise
their prices, causing widespread panic. In response,
the emperor Diocletian issued what’s now known as
the Edict on Maximum Prices, a series of price and
wage controls designed to stop the rise of prices
and wages (one helpful control was a maximum
price for a male lion). But because the edict didn’t
address the root cause of inflation—the impure
silver coin—it didn’t fix the problem.
How is inflation measured?
What are some periods in history
with high inflation?
Economists frequently compare the current
inflationary period with the post–World War II era,
when price controls, supply problems, and
extraordinary demand in the United States fueled
double-digit inflation gains—peaking at 20 percent
in 1947—before subsiding at the end of the decade.
Consumption patterns today have been similarly
distorted, and supply chains have been disrupted
by the pandemic.
Statistical agencies measure inflation first by
determining the current value of a “basket” of
various goods and services consumed by
households, referred to as a price index. To
calculate the rate of inflation over time, statisticians
compare the value of the index over one period with
that of another. Comparing one month with another
What is inflation?
3
gives a monthly rate of inflation, and comparing
from year to year gives an annual rate of inflation.
In the United States, the Bureau of Labor Statistics
publishes its Consumer Price Index (CPI), which
measures the cost of items that urban consumers
buy out of pocket. The CPI is broken down by
region and is reported for the country as a whole.
The Personal Consumption Expenditures (PCE)
price index—published by the US Bureau of
Economic Analysis—takes into account a broader
range of consumer spending, including on
healthcare. It is also weighted by data acquired
through business surveys.
How does inflation affect consumers
and companies differently?
Inflation affects consumers most directly, but
businesses can also feel the impact:
— Consumers lose purchasing power when the
prices of items they buy, such as food, utilities,
and gasoline, increase. This can lead to
household belt-tightening and growing
pessimism about the economy.
— Companies lose purchasing power and risk
seeing their margins decline, when prices
increase for inputs used in production. These
can include raw materials like coal and crude oil,
intermediate products such as flour and steel,
and finished machinery. In response, companies
typically raise the prices of their products or
services to offset inflation, meaning consumers
absorb these price increases. The challenge for
many companies is to strike the right balance
between raising prices to cover input cost
increases while simultaneously ensuring that
they don’t raise prices so much that they
suppress demand.
How can organizations respond to
high inflation?
During periods of high inflation, companies typically
pay more for materials, which decreases their
margins. One way for companies to offset losses
and maintain margins is by raising prices for
consumers. However, if price increases are not
executed thoughtfully, companies can damage
customer relationships and depress sales—
ultimately eroding the profits they were trying
to protect.
When done successfully, recovering the cost of
inflation for a given product can strengthen
relationships and overall margins. There are five
steps companies can take to ADAPT (adjust,
develop, accelerate, plan, and track) to inflation:
— Adjust discounting and promotions and
maximize nonprice levers. This can include
lengthening production schedules or adding
surcharges and delivery fees for rush or lowvolume orders.
— Develop the art and science of price change.
Instead of making across-the-board price
changes, tailor pricing actions to account for
inflation exposure, customer willingness to pay,
and product attributes.
— Accelerate decision making tenfold. Establish
an “inflation council” that includes dedicated
cross-functional, inflation-focused decision
makers who can act quickly and nimbly on
customer feedback.
— Plan options beyond pricing to reduce costs.
Use “value engineering” to reimagine a portfolio
and provide cost-reducing alternatives to
price increases.
— Track execution relentlessly. Create a central
team to address revenue leakage and to
manage performance rigorously. Traditional
performance metrics can be less reliable when
inflation is high.
What is inflation?
4
Beyond pricing, a variety of commercial and
technical levers can help companies deal with price
increases in an inflationary market, but other
sectors may require a more tailored response
to pricing.
Learn more about our Financial Services,
Industrials & Electronics, Operations, Strategy &
Corporate Finance, and Growth, Marketing &
Sales Practices.
How can CEOs help protect their
organizations against uncertainty
during periods of high inflation?
In today’s uncertain environment, in which
organizations have a much wider range of
stakeholders, leaders must think about performance
beyond short-term profitability. CEOs should lead
with the complete business cycle and their
complete slate of stakeholders in mind.
CEOs need an inflation management playbook, just
as central bankers do. Here are some important
areas to keep in mind while scripting it:
— Design. Leaders should motivate their
organizations to raise the profile of design to a
C-suite topic. Design choices for products and
services are critical for responding to price
volatility, scarcity of components, and higher
production and servicing costs.
— Supply chain. The most difficult task for CEOs
may be convincing investors to accept supply
chain resiliency as the new table stakes. Given
geopolitical and economic realities, supply chain
resiliency has become a crucial goal for supply
chain leaders, alongside cost optimization.
— Procurement. CEOs who empower their
procurement organizations can raise the bar on
value-creating contributions. Procurement
leaders have told us time and again that the
current market environment is the toughest
they’ve experienced in decades. CEOs are
beginning to recognize that purchasing leaders
can be strategic partners by expanding their
focus beyond cost cutting to value creation.
— Feedback. A CEO can take a lead role in playing
back the feedback the organization is hearing.
In today’s tight labor market, CEOs should guide
their companies to take a new approach to
talent, focusing on compensation, cultural
factors, and psychological safety.
— Pricing. Forging new pricing relationships
with customers will test CEOs in their role as
the “ultimate integrator.” Repricing during
inflationary times is typically unpleasant for
companies and customers alike. With setting
new prices, CEOs have the opportunity to
forge deeper relationships with customers, by
turning to promotions, personalization, and
refreshed communications around value.
— Agility. CEOs can strive to achieve a focus
based more on strategic action and less on
firefighting. Managing the implications of
inflation calls for a cross-functional, disciplined,
and agile response.
What is inflation?
5
A practical example: How is inflation
affecting the US healthcare industry?
Consumer prices for healthcare have rarely risen
faster than the rate of inflation—but that’s what’s
happening today. The impact of inflation on the
broader economy has caused healthcare costs to
rise faster than the rate of inflation. Experts also
expect continued labor shortages in healthcare—
gaps of up to 450,000 registered nurses and
80,000 doctors—even as demand for services
continues to rise. This drives up consumer prices
and means that higher inflation could persist.
McKinsey analysis as of 2022 predicted that the
annual US health expenditure is likely to be
$370 billion higher by 2027 because of inflation.
This climate of risk could spur healthcare leaders to
address productivity, using tech levers to boost
productivity while also reducing costs. In order to
weather the storm, leaders will need to quickly set
high aspirations, align their organizations around
them, and execute with speed.
What is deflation?
If inflation is one extreme of the pricing spectrum,
deflation is the other. Deflation occurs when the
overall level of prices in an economy declines and
the purchasing power of currency increases. It can
be driven by growth in productivity and the
abundance of goods and services, by a decrease in
demand, or by a decline in the supply of money
and credit.
Generally, moderate deflation positively affects
consumers’ pocketbooks, as they can purchase
more with less money. However, deflation can be a
sign of a weakening economy, leading to recessions
and depressions. While inflation reduces
purchasing power, it also reduces the value of debt.
During a period of deflation, on the other hand,
debt becomes more expensive. And for consumers,
investments such as stocks, corporate bonds, and
real estate become riskier.
A recent period of deflation in the United States
was the Great Recession, between 2007 and 2008.
In December 2008, more than half of executives
surveyed by McKinsey expected deflation in their
countries, and 44 percent expected to decrease the
size of their workforces.
When taken to their extremes, both inflation and
deflation can have significant negative effects on
consumers, businesses, and investors.
For more in-depth exploration of these topics, see
McKinsey’s Operations Insights collection. Learn
more about Operations consulting, and check out
operations-related job opportunities if you’re
interested in working at McKinsey.
Articles referenced:
— “Investing in productivity growth,” March 27,
2024, Jan Mischke, Chris Bradley, Marc Canal,
Olivia White, Sven Smit, and Denitsa Georgieva
— “Economic conditions outlook during turbulent
times, December 2023,” December 20, 2023
— “Forward Thinking on why we ignore
inflation—from ancient times to the present—at
our peril with Stephen King,” November 1, 2023
— “Procurement 2023: Ten CPO actions to defy
the toughest challenges,” March 6, 2023,
Roman Belotserkovskiy, Carolina Mazuera,
Marta Mussacaleca, Marc Sommerer, and
Jan Vandaele
What is inflation?
6
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— “Why you can’t tread water when inflation is
persistently high,” February 2, 2023, Marc
Goedhart and Rosen Kotsev
— “Pricing during inflation: Active management can
preserve sustainable value,” August 19, 2022,
Niels Adler and Nicolas Magnette
— “Markets versus textbooks: Calculating
today’s cost of equity,” January 24, 2023,
Vartika Gupta, David Kohn, Tim Koller, and
Werner Rehm
— “Navigating inflation: A new playbook for CEOs,”
April 14, 2022, Asutosh Padhi, Sven Smit, Ezra
Greenberg, and Roman Belotserkovskiy
— “Inflation-weary Americans are increasingly
pessimistic about the economy,” December 13,
2022, Gonzalo Charro, Andre Dua, Kweilin
Ellingrud, Ryan Luby, and Sarah Pemberton
— “Inflation fighter and value creator: Procurement’s
best-kept secret,” October 31, 2022, Roman
Belotserkovskiy, Ezra Greenberg, Daphne
Luchtenberg, and Marta Mussacaleca
— “Prime Numbers: Rethink performance metrics
when inflation is high,” October 28, 2022,
Vartika Gupta, David Kohn, Tim Koller, and
Werner Rehm
— “The gathering storm: The threat to employee
healthcare benefits,” October 20, 2022, Aditya
Gupta, Akshay Kapur, Monisha MachadoPereira, and Shubham Singhal
— “Utility procurement: Ready to meet new
market challenges,” October 7, 2022, Roman
Belotserkovskiy, Abhay Prasanna, and
Anton Stetsenko
— “How business operations can respond to price
increases: A CEO guide,” March 11, 2022,
Andreas Behrendt, Axel Karlsson, Tarek Kasah,
and Daniel Swan
— “Five ways to ADAPT pricing to inflation,”
February 25, 2022, Alex Abdelnour, Eric
Bykowsky, Jesse Nading, Emily Reasor, and
Ankit Sood
— “How COVID-19 is reshaping supply chains,”
November 23, 2021, Knut Alicke, Ed Barriball,
and Vera Trautwein
— “Navigating the labor mismatch in US logistics
and supply chains,” December 10, 2021, Dilip
Bhattacharjee, Felipe Bustamante, Andrew
Curley, and Fernando Perez
— “Coping with the auto-semiconductor shortage:
Strategies for success,” May 27, 2021,
Ondrej Burkacky, Stephanie Lingemann,
and Klaus Pototzky
This article was updated in April 2024; it was
originally published in August 2022.
— “The gathering storm: The transformative impact
of inflation on the healthcare sector,”
September 19, 2022, Addie Fleron, Aneesh
Krishna, and Shubham Singhal
Get to know and directly engage with senior McKinsey experts on inflation.
Ondrej Burkacky is a senior partner in McKinsey’s Munich office, Axel Karlsson is a senior partner in the
Stockholm office, Fernando Perez is a senior partner in the Miami office, Emily Reasor is a senior partner in
the Denver office, and Daniel Swan is a senior partner in the Stamford, Connecticut, office.
Copyright © 2024 McKinsey & Company. All rights reserved.
What is inflation?
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