Inflation affects all aspects of the economy – from everyday consumer spending to government tax policies. Understanding inflation is important to everyone as it erodes your purchasing power over time, meaning that the same $5 that you have today will get you less in 5 years. Since, in recent years, inflation has started to increase to its highest level in decades, it’s worth knowing what this does and doesn’t mean for your money.
What is inflation?
Inflation is part of the natural cycle of growth in the economy. It refers to the overall increase in prices across the economy over time and the decrease in purchasing power. In simpler terms, goods (e.g., cars and groceries) and services (e.g., Netflix subscription and haircuts) get more expensive, so your dollars don’t go as far today as a year ago.
Think about your daily cup of coffee. Today $5 could get you 1.5 coffees, but in 1973 $5 could have got you 10 cups! Over time as the price of goods increases, the purchasing power of your $$ decreases. Check out Yahoo Finance’s Cost of Coffee calculator to find out how far your $5 would have stretched in previous years. How many cups would you have had in 1940 from $5?!
What causes inflation?
As the economy grows, businesses and consumers spend more money on goods and services. For example, we use many more cars than we did 30 years ago. At some point in time, the demand for private vehicles becomes greater than the supply, so car manufacturers can increase the prices of cars because there will be people willing to buy them. An extreme example of high inflation would be hand sanitizer and mask prices in 2020, as the COVID-19 pandemic increased the demand for these goods overnight. Now imagine this price increases on a slower, broader scale for all goods over time, and that sustained price increase is inflation. As grocery stores, gas stations, or manufacturers increase their prices, the rate of inflation increases.
Some levels of inflation are good (around 2-3% in the U.S.) because it is a natural result of a growing economy. However, above a certain level, high inflation can become a worrisome sign. These times are characterized by rapidly increasing prices. Prices can rise due to higher manufacturing costs which pass on to consumers. For example, an increase in the cost of milk production will increase the price of milk in grocery stores. An increase in prices can also result from a rapid rise in demand that manufacturers can’t keep up with, like in the above example of hand sanitizers and masks during the pandemic. It is rare, but the economy can also enter an uncontrollable upward spiral of increasing inflation called “runaway inflation” or “hyperinflation.”
How is inflation measured?
There are several ways to measure and report inflation. Two key price indexes for measuring inflation are:
CPI comes from the Bureau of Labor Statistics and measures the cost of items consumers buy out of pocket. It can be broken down by region and reported for the country as a whole. PCE comes from the Bureau of Economic Analysis and considers a broader range of consumer expenditures, including healthcare. Each measure can be used for different groups of goods and services – headline (overall) and core (excludes food and energy) measures.
Economists tend to focus on core measures, the rate of inflation, excluding food and energy prices which are susceptible to sharp short-term changes in price, which can mislead the picture of inflation. “Core inflation” measures include “core CPI” or “core PCE.” The U.S. Federal Reserve uses the core PCE as its primary measure of inflation.
What are the effects of inflation?
Inflation increases the cost of living and puts pressure on household budgets. If wages do not increase in line with the prices of goods, then purchasing power decreases, and people have to adjust their spending. This can disproportionately impact communities living paycheck to paycheck or with little wiggle room in their monthly expenditures.
Inflation exacerbates income inequality as:
- Essential products take up a larger proportion of the budget of low-income households than other income groups. Increases in the prices of basic needs (food or electricity etc.) can result in the poorest families spending all their income on essentials.
- Consumption of essential products and services like groceries, heating, electricity, etc., cannot be reduced without harming these communities. If beer or coffee prices rise, you would probably just drink less, but the choice is much harder when your food and heating bills increase.
- These groups have the fewest financial options to buffer and absorb the effects of inflation. High-income households can reallocate their budgets, tap into their savings, and use their credit cards and other sources of money to buffer unexpected price rises.
What do governments do about inflation?
Central banks and governments attempt to control inflation by regulating the pace of economic activity. This can be done in several ways.
- Monetary policy. Central banks can manage the money supply in their local economies. Raising and lowering interest rates is the most common strategy. Lowering interest rates encourages businesses and consumers to borrow money to spend on activities that stimulate economic growth while rising interest rates make borrowing more expensive and slow economic activity.
- Fiscal policy. The federal government can also manage inflation through its spending and tax policies. The government can increase its spending to stimulate economic growth. Hence these spending policies are also referred to as stimulus spending. Conversely, they can also curb economic growth and inflation by reducing spending. Similarly, by increasing taxes, consumers and businesses will have less money to spend, slowing economic growth.
How can my money beat inflation?
While regulating the economy lies in the power of governments, you can invest your money to overcome inflation. With investing, you can retain the purchasing power of your dollars, and it is a more effective way to beat inflation rather than keeping your money sitting in a savings account.
However, inflation can also affect the performance of your investments. You can mitigate the risks of inflation by:
- Maintaining a diversified portfolio by investing your money in companies across various industries and geographies. This can help reduce the risk and fluctuations in your investments.
- Rebalancing on a periodic to adjust your portfolio and rotate your money into investments that may do better in times of inflation
- Keep a safety buffer in the form of a rainy day fund for times of uncertainty.
Inflation is a natural part of economic growth and shouldn’t be feared. In fact, moderate inflation levels are a sign of a strong economy! However, it is essential to understand that inflation erodes your purchasing power, so keeping your money under the mattress or leaving it sitting in a savings account will lose you money over time. If you want your money to work for you and keep up or even beat inflation, your only option is to invest. FLIT Invest is here to help you start your investment journey to grow your wealth while making an impact.
Footnote 1: Content is for informational and educational purposes only. Any views, strategies or products discussed may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. The information contained herein should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund or ETF before investing.