How Layers of Inflation Affect Consumer Prices
Peeling the inflation onion reveals the factors influencing consumer pricing trends, Fed policy and investor portfolios.
Key Takeaways
Like an onion, inflation has several layers. Peeling back these layers illustrates how different goods and services broadly affect consumer prices.
For the Fed, setting monetary policy includes gauging a complex mix of backward-looking economic data and expectations for future prices.
While no investment is immune from inflation, certain choices, like Treasury inflation-protected securities, may help ease the impact of rising prices.
Inflation has many analogies, but have you ever thought of it as an onion?
Just as peeling an onion can bring tears to your eyes, paying higher prices at the grocery store can be equally uncomfortable. However, the analogy goes deeper. Like an onion, inflation has multiple layers that reveal its complexities.
Let's peel back these layers to understand what drives inflation and how it influences the Federal Reserve’s (Fed’s) policy decisions and investor portfolios.
Three Layers of Inflation
John C. Williams, president and CEO of the Federal Reserve Bank of New York, has compared inflation to an onion with the three layers depicted in Figure 1.1
Figure 1 | Peeling the Inflation Onion
The Outer Layer
The outer layer of the inflation onion includes globally traded commodities like food, energy and raw materials, making it the most volatile layer.
During the pandemic, these prices soared because of supply and demand imbalances. Similarly, the Russia/Ukraine war drove energy and grain prices higher, forcing producers to pass on price hikes to consumers. Now, tariffs threaten this layer.
The Middle Layer
Core goods, such as appliances, furniture and cars (but not food and energy), comprise the middle layer of the inflation onion. Short-term inflation expectations, import prices and tariffs typically influence core goods inflation.
Tariffs will likely have the most immediate impact on the outer and middle layers of the inflation onion, potentially pushing consumer prices higher. Any resulting increase in the core inflation rate could force the Fed to raise interest rates. However, if tariffs also trigger a notable slowdown in economic growth, the Fed may find itself in a conundrum.
Some economists believe fiscal stimulus, tax and regulation cuts, increased domestic energy production and onshoring could offset the effects of tariffs.
The Inner Layer
This layer consists of core services, which are the trickiest to control because they typically change slowly. The inner layer includes shelter (rent, owners’ equivalent rent and lodging) and services like education and barber visits.2 Core services minus housing services defines the Fed’s “super core” inflation measure, which is most sensitive to wage growth.
Some economists isolate housing services from inflation equations because housing prices have diverged from other goods and services prices in recent years.3 For example, core goods and services prices generally moderated post-pandemic, while housing costs have remained stubbornly elevated, as Figure 2 shows.
Figure 2 | Housing Has Made an Outsized Contribution to Core Inflation
Data from 1/31/2012 – 12/31/2024. Source: FactSet. Core inflation is measured by the Consumer Price Index (CPI).
Putting the Onion in Context
Because economic data is backward-looking, the Fed must implement policy based on its best inflation forecast. Therefore, policymakers are less concerned about one-off events than persistent inflation trends. In general, prices comprising the core of the onion — which the Fed finds most useful — are less likely to change dramatically.
For example, a jump in oil prices on the outermost layer of the inflation onion may be less concerning than material changes in transportation services. A notable rise in core services, largely due to its strong link to wage growth, may signal mounting inflationary pressures.4
Tariffs Could Change the Game
Responses to President Donald Trump’s tariff policy from our global trading partners represent a wildcard for the inflation backdrop. Depending on the specific tariff’s structure and duration, producers could either absorb the additional cost or pass along higher prices to consumers.
Shifting policy and tariffs could affect commodities and goods prices, creating an uptick in inflation. Eventually, this could even affect the inner layer of the onion, particularly if wage pressures build.
However, the extent and persistence of rising prices are up for debate. Is Trump using tariffs to negotiate better trade deals and other agreements for the U.S.? Or are tariffs part of his administration’s long-term policies?
Unlike the trade wars of Trump’s first term, today’s tariffs may likely affect everything from gaming consoles to toys to shoes, hitting squarely in the middle layer of the onion.5 The inflation climate is materially different today than during Trump’s first term when core inflation was consistently at or near the Fed’s 2% goal.6
What Drives Inflation?
A Complex Web of Supply and Demand Forces
Following the Global Financial Crisis, inflation lingered at historically low levels. This stopped in 2021 when inflation soared to multidecade highs amid pandemic-related effects. Inflation has since moderated but has remained elevated relative to pre-2021 levels and the Fed’s target.
Several forces can pressure prices and drive the inflation rate higher, including:
Supply issues. Supply chain bottlenecks, raw material shortages and labor shortages can trigger “cost-push” inflation.
Demand surges. Prices rise when demand for goods or services outstrips supply or production capacity. We’ve recently seen this in the housing market, where strong demand and limited supply have contributed to rising prices.
Government spending. When the government prints money to finance its spending, the nation’s money supply grows. And when more money goes into circulation, the dollar’s value declines, causing prices to rise.
Consumer expectations. When consumers expect higher inflation in the future, their behavior can make it a reality. For example, employees can demand higher wages, prompting businesses to raise prices.
From the Fed to You: Avoiding the Tears of the Inflation Onion
We all feel the pinch of higher prices at the grocery store, but higher prices have more profound consequences over time. Higher inflation ultimately erodes your purchasing power. If prices increase and your income doesn’t rise at the same pace, your dollars won’t go as far.
Inflation can also erode your investment returns. “Inflation risk” refers to the possibility that your investment performance won’t keep up with the pace of inflation. If you’re retired or nearing retirement, this is a critical consideration for meeting your income goals.
No Asset Class Is Immune to Inflation, but Some Are Designed to Help
No investment asset class is wholly protected from inflation risk, but fixed-income securities may be more vulnerable. For example, when inflation rises, interest rates typically increase, too. But rising rates make existing bonds with lower rates less attractive, and their prices decline.
Similarly, inflation erodes the purchasing power of a bond’s fixed interest payment. Consider a bond that pays $500 in interest annually. A persistently high or steadily rising inflation rate will stifle the future buying power of the bond’s annual interest payment.
However, some fixed-income securities offer better inflation-fighting potential, underscoring the possible appeal of holding a diversified bond portfolio. For example, Treasury inflation-protected securities (TIPs) are designed to protect investors against inflation.
The face, or principal, value of TIPS adjusts along with the inflation rate. So, when inflation rises, TIPS’ values also rise (and when inflation drops, TIPS’ values decline). Moreover, when inflation rises, the interest payments from TIPS also increase because those payments are based on the adjusted principal value.
Diversified Assets Are Your Onion Goggles
As Figure 3 illustrates, a diversified portfolio of stocks, bonds and real assets can help curtail the negative effects of inflation. Over time, many asset classes have historically delivered returns that outpaced inflation.
Figure 3 | Asset Classes vs. Inflation
Data from 12/31/1994 – 12/31/2024. Source: FactSet. Past performance is no guarantee of future results. U.S. stocks are represented by the S&P 500 Index. U.S. bonds are represented by the Bloomberg U.S. Aggregate Bond Index. U.S. TIPS are represented by the Bloomberg U.S. TIPS Index. U.S. REITs are represented by the FTSE NAREIT All Equity REITs Index. Core inflation is measured by CPI.
Other assets, such as real estate, have a built-in resilience to inflation. Real estate investment trusts (REITs), for example, generate interest income from rents. They deliver the potential to increase in value because property costs and rent prices tend to increase over time and during inflationary periods.
Our favored strategy is to work with a financial professional to maintain a diversified investment portfolio. Assembling an asset mix attuned to your goals, risk tolerance and investment horizon may help preserve long-term purchasing power.
Stay Vigilant About Sticky Inflation
Unpeeling the layers of the inflation onion illustrates how the Fed dissects inflation and steers policy. Given today’s uncertainty surrounding tariffs and global trade, a resurgence in inflation remains a possibility.
In the meantime, ensuring that your investment portfolio is broadly diversified is likely a prudent strategy.
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John C. Williams, “Peeling the Inflation Onion, Revisited,” Virtual Remarks Prepared for a Regional Visit to Long Island, September 29, 2023, Bank for International Settlements (BIS).
Owner’s equivalent rent represents the estimated amount a homeowner would pay to rent their current residence or the rental income they forgo by occupying their own home rather than renting it; Chair Jerome H. Powell, Speech on Inflation and the Labor Market at the Brookings Institution, Board of Governors of the Federal Reserve System, November 30, 2022.
Martin Almuzara, Marek Jarocinski, and Argia Shordone, “The Layers of Inflation Persistence,” Liberty Street Economics, Federal Reserve Bank of New York, January 5, 2023.
Christopher J. Neely, “Measuring Inflation: Headline, Core and ‘Supercore’ Services,” Federal Reserve Bank of St. Louis, May 3, 2024.
Laura Wamsley, “Here’s How Trump’s Tariffs Could Cost You and Your Wallet, NPR, March 4, 2025.
Colby Smith, “Can the Fed Look Past Trump’s Tariffs?” New York Times, February 17, 2025.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Diversification does not assure a profit nor does it protect against loss of principal.