One of the most familiar terms in economics is a concept not many people understand, yet we all experience and feel its effects—inflation. It has plunged countries into extended periods of instability. Politicians have earned election victories with promises to tackle inflation, only to lose power after failing to do so. In 1974, President Gerald Ford declared inflation to be America’s Public Enemy No. 1. What, then, is inflation, and why is it so important?
Americans are already forking out more for everyday expenses from groceries and clothing to cars, gas, and computers. Consumers are now using their stashed cash, enhanced unemployment benefits, and stimulus checks to run the purchasing gauntlet. However, all that spending is only driving prices higher and reducing your purchasing power over time.
Understanding inflation and how it impacts your finances will help you make better decisions regarding investing and saving your money in the long run. Otherwise, you could inadvertently make decisions that cause your pot to shrink or miss out on opportunities to grow your money. Today, our Money Wizards seek to debunk inflation myths and provide clarity into how inflation affects you.
What Is Inflation?
Inflation is simply the rate at which prices increase over a specific period. Often, inflation is a broad metric, such as the increase in cost of living or in prices across an entire nation. However, it can also be narrowly calculated for specific goods like food or for services. Whatever the parameters, inflation tells us how much more costly goods and services have become over a given period, usually a year.
All the items you spend your cash on—rent, milk, movie tickets—can be rolled up together to come up with what is commonly known as the cost of living. As the cost of living soars—a number typically reflected in the consumer price index (CPI)—the dollar that could buy three chocolate bars now only just buys one. That is inflation.
Inflation erodes the value of money over time, resulting in price increases across multiple sectors and industries. When prices rise, your dollars don’t go as far as they used to. Think about someone who had $10,000 in the bank in the 1980s versus $10,000 in the bank today. Who has more purchasing power? That $10,000 from the 1980s would buy more than it can buy today because today’s prices on most items are vastly higher than the prices on those same items from decades ago.
What Causes Inflation?
Simply put, inflation occurs when the dollar’s purchasing power shrinks to the degree that the would-be supply of dollars fills out faster than actual demand to hold those dollars. Here are a few factors that may spur inflation at any given time.
1. A Growing Economy
In an expanding or growing economy, unemployment levels drop, and wages increase. As a result, people have more money in their pockets, which increases their purchasing and spending power on both necessities and luxuries. This increased demand lets suppliers raise prices, which in turn puts more money in circulation.
In this context, inflation is viewed as a positive thing since it’s a sign of a humming economy, because a growing economy may increase consumer demand and spending in what is called demand-pull inflation.
2. Rising Commodity Prices
Soaring commodity prices are an example of cost-push inflation. They are arguably the most obvious inflationary force since when commodity prices increase, the costs of almost all goods and services inevitably follow suit. Rising oil prices, in particular, often have the most pervasive impact on an economy. First, petrol or gasoline prices will rise. The aftermath is that the prices of all goods and services transported by rail, road, or ship will also increase. Jet fuel prices will also increase, which raises the price of airline transport and airline tickets.
By triggering price increases for both consumers and businesses, rising oil prices take more money out of the pockets of all players in the economy. Economists often view oil price hikes as in effect a “tax” that can strain an already struggling economy.
3. Expansion of the Money Supply
An expanded supply of money can also trigger inflation, more specifically demand-pull inflation. This can occur if the Federal Reserve rapidly increases the money supply without a corresponding increase in the production of goods and services. With more money circulating, the composite demand in an economy soars too fast. This outstrips supply, which eventually increases prices.
4. Changes in Exchange Rates
Changes in exchange rates can cause the value of the U.S. dollar to plummet in relation to foreign currency. As its value depreciates, imported goods become more expensive and costs rise, which puts more pressure on prices.
Over the long haul, currencies of countries experiencing higher inflation rates tend to depreciate relative to those with lower inflation rates. Since inflation will erode the value of investment returns, investors will move their money to countries experiencing lower inflation rates.
5. Government Regulation
The government may impose new tariffs or laws that make it more expensive for companies to produce or import goods. For instance, if a government increases its sales tax and excise duty, the trickle-down effect will be higher prices and eventually a higher CPI. Higher taxes mean higher expenses for consumers, which will result in some form of cost-push inflation.
The Federal Reserve is mandated to manage inflation, usually with an explicit target of keeping it at around 2%. Low inflation could indicate sluggish demand for goods and services, implying that the economy is headed for a potential slowdown or recession. The same results may occur when inflation is too high.
Why and When Should You Care About Inflation
Most of us view inflation as a double-edged sword that hurts businesses and consumers alike. However, inflation can also be a good thing. When prices rise due to an expanding economy, this is often accompanied by an increase in wages and income, since a robust economy means lower unemployment and more intense competition for labor. So, your favorite snack might be more expensive, but you can afford it since your paycheck is a little higher.
If prices go up because of tariffs (taxes on exports and imports) or quotas, this can cause goods and services to be more expensive without a corresponding increase in incomes. That hurts, and you’ll want to give a second thought to inflation.
You should care about inflation because it impacts what you can do with your money. How so? As the prices of goods and services increase, the purchasing power of money falls. The implication is that, with the same amount of money, you won’t be able to buy the same number of items today as you would have several months ago.
Another reason to care about inflation is that it affects how you manage your money. If inflation is at 2%, we will naturally be inclined to put money into investment and savings products that pay higher than that rate. This will ensure that every dollar earned retains its purchasing power over the long haul.
Sure, inflation may mean that there’s a healthy amount of economic activity taking place, but you should be wary of it when it starts eating into the value of your assets.
How Inflation Personally Affects You
While inflation affects each of us differently, it broadly affects consumers in terms of both income and expenses. Here’s how inflation personally affects you:
- It erodes your purchasing power. The best-known effect of inflation is the erosion of your purchasing power. As inflation occurs and goods and services become more expensive, a single unit of currency will lose its value since it can buy fewer goods and services. This will affect the cost of living of consumers, who will be able to buy fewer items.
- Cost of housing. Inflation may also affect the cost of housing. If you currently rent your home, your landlord may increase your rent every year to account for inflation.
- Your retirement plan is at risk. For retirees, rising prices from inflation will only present additional risks. If you’re like many older Americans and operate on a fixed budget, absorbing higher costs can hit you hard. You may also be paying for hefty medical expenses beyond the rising costs of food and housing.
- It becomes more expensive to borrow. Usually, when inflation rises, your salary or wages should be adjusted accordingly in what is known as a cost-of-living adjustment. However, if inflation increases, but your wages stay the same, your money won’t cover as much as it previously did. You may choose to borrow money to bridge the gap, which will come at an extra cost since interest rates tend to follow inflation.
What You Should Do in an Inflationary Environment
Inflation erodes the purchasing power of your money, so you must be strategic in protecting your money from it. Here’s what you should do in an inflationary environment:
- Don’t stash your cash at home. The first thing to do in an inflationary environment is to take out all the money stashed under the mattress. Keeping your money this way will only cause it to lose value over time, and the longer you hold it, the more inflation will eat into it. The best move for you is to deposit your money in a high-interest savings account. You may also channel it toward investment products that generate higher returns.
- Negotiate a salary raise. You’ll feel the effect of inflation if your annual salary doesn’t keep up with the inflation rate. As a result, you can protect your money from the impact of inflation by negotiating a salary raise. This will ensure your salary is adjusted to cover cost-of-living expenses.
- Put most of your money in investments. Another action to take in an inflationary environment is to invest most of your money. When you put your money in stocks and bonds for long-term growth, you stand a higher chance of earning returns that beat inflation.
- Review your expenses. Inflation will cause your costs to increase, so it’s time to review and rethink what you need to remove from your household basket. Eliminating any unnecessary expenses will give you more purchasing power for the essentials of life.
How Can You Plan for Inflation?
Sometimes, economists can predict when inflation will occur, but there’s usually a high level of uncertainty. Inflation is unpredictable, and that’s why you should always be aware of the risk it poses for your finances. So, how can you plan for inflation?
Invest in stocks
Although many people express a lack of confidence in stocks, owning equities can put you in good financial shape if inflation kicks in. Some of the best stocks to own are those in the consumer staples sector since these companies produce and sell items that are essential for everyday living. As a result, consumers will buy them irrespective of prevailing market conditions.
A diversified portfolio with the right mix of equities and fixed income investments can help you grow returns faster than inflation and thus build wealth. Equity funds can provide the benefit of capital growth and dividend income during times of economic uncertainty.
Buy a home
While this may not be a priority for many, it’s an excellent way to plan for inflation, especially if you’re eyeing a mortgage. It’s easier to pay off a mortgage when interest rates are still low than when interest rates start rising due to inflation.
Increase the amount you’re saving for retirement
Another great strategy to deal with inflation is to increase the amount you’re setting aside for retirement each pay period. If your retirement savings stay ahead of inflation, you’ll be better prepared to meet your retirement income needs and handle future increases in the cost of living.
Simply put, inflation implies that the value of every dollar you have is constantly decreasing. Saving $3,000 in today’s context will buy much less in 10 years. While you can’t avoid the effects of inflation altogether, having a solid financial plan should guard you against inflation and help maintain your buying power and standard of living. A smart move in the wake of inflation is to invest your money in assets that outrun the rate of inflation.