If you’ve been paying attention to the news lately, you’ve likely heard one word consistently showing up in financial headlines:
Inflation is a significant economic factor affecting most individuals and their financial well-being. But what is it, exactly?
Inflation is defined as a general increase in prices and a decrease in the purchasing value of money. Inflation happens for many different reasons. Production cost increases, increase in demand, global events, and changing fiscal policy at a government level can all be contributing factors.
The average annual rate of inflation from 1960 to 2022 was 3.8%. However, in 2022, the average rate of inflation ballooned to 8%. As of May 2023, the year-over-year inflation rate was 4.0%. Recently, the Federal Reserve has been working to increase interest rates to slow inflation – even though that can bring a new layer of financial complexity for investors.
Needless to say, there have been significant inflation changes over the past few years. While it seems to be easing in the first two quarters of 2023, it largely remains on the minds of investors and consumers. Regardless of “why” inflation happens, understanding how inflation impacts finances is crucial for making informed money decisions and safeguarding financial stability.
Here are three key areas to help you understand how inflation impacts your financial situation.
Become an educated investor
1. Purchasing Power Erosion
One of the primary impacts of inflation is the erosion of purchasing power. Purchasing power is essentially how much your money can buy in the current economic state.
Inflation reduces the value of money over time. Meaning, as prices rise, the same amount of money can buy fewer goods and services.
For example, if the inflation rate is 3%, the price of goods and services will generally increase by that amount each year. Consequently, the money you have today will have less buying power in the future.
One common example of inflation is the cost of milk or eggs at the grocery store. Let’s say in 1960 a gallon of milk cost $1. Today, the cost of milk ranges between $2.99 and $4 depending on where you live in the United States. Just looking at the price of milk alone, you can see how having $1,000 in savings for living expenses in 1960 would have dramatically different purchasing power than having $1,000 in savings today. As products and services increase their costs, the amount of goods and services your money can purchase decreases.
This erosion of purchasing power can affect your ability to maintain the same standard of living and achieve long-term financial goals.
The CPI, or Consumer Price Index, is one way to stay updated on purchasing power. This index is how the government measures the prices of goods and services as they fluctuate. It looks something like this:
Exhibit 1: Percent changes in CPI for All Urban Consumers (CPI-U): U.S. city average
Exhibit 1. Percent changes in CPI for urban customers in the US from November 2022 to May 2023. From the Consumer Price Index Summary by the US Bureau of Labor and Statistics. (https://www.bls.gov/news.release/cpi.nr0.htm)
Since the index is published monthly, it is a solid way to stay informed about current consumer goods and services costs. You might even use it to your advantage, for instance, to negotiate your salary by giving an employer concrete numbers to reference.
Also note that inflation typically occurs during periods of economic strength. This means you can anticipate living through such a period that your costs will most likely be driven up, affecting your purchasing power. Staying ahead of trends can be key here.
2. Savings and Investments Effects
Unfortunately, inflation doesn’t just affect purchasing power for goods and services, it can also harm savings and investments.
The reason? If interest rates on savings accounts or fixed-income investments do not keep up with inflation, the actual value of your savings can decrease over time.
For instance, if your savings account offers an interest rate of 2% while inflation is 3%, you are effectively losing purchasing power.
Inflation also decreases the values of bonds. The longer the term of a bond, the greater the risk that inflation will hurt the investor’s return. Let’s say you purchased bonds at a fixed interest rate of 0.90% for a term of 10 years. If the Federal Reserve chooses to increase interest rates to combat inflation, this could result in a decreased bond value over time. However, it’s important to note that not all bonds are equally impacted by inflation. Short-term bonds, for example, are less impacted by inflation and interest rate changes.
Another type of account to keep in mind regarding inflation is retirement savings accounts. Many people set a savings goal for retirement without considering how different the economy will inevitably be or what the dollar will be worth once they’ve reached retirement age. Plan on knowing what an even higher number looks like, as your current goals will likely not have the same value in the future.
To combat inflation with your savings and investments, it’s crucial to consider investment options that have the potential to outpace inflation, such as stocks, real estate, or diversified portfolios. Investing in assets that historically provide returns higher than the inflation rate can help preserve and grow your wealth.
3. Budgeting and Financial Planning Adjustments
People often feel the sting of inflation most directly in personal budgeting and financial planning. That’s because rising costs seep into many aspects of everyday living expenses like housing, groceries, transportation, and healthcare, to name a few.
When creating your budget, it’s essential to anticipate and account for these increasing costs. Review your spending patterns, identify areas where you can adjust, and prioritize saving and investing.
By proactively adjusting your financial plan and budgeting strategies, you can better navigate the challenges posed by inflation.
The Future’s Still Bright
Inflation can significantly impact your finances – from diminishing your purchasing power to influencing your savings and investments.
A little knowledge can truly equal power. Being passive with your finances or in denial about the economic climate will likely catch you off guard and potentially more burdened by inflation.
Instead, by understanding how inflation affects your financial situation, you can anticipate those changes, make informed decisions, and take proactive steps to mitigate its impact.
Knowledge only helps though if it’s backed up by action. When taking action on inflation, be sure to incorporate the following into your financial planning:
- Regularly reassess your financial plans and make adjustments when needed
- Consider seeking advice from financial experts to ensure your financial stability in the face of inflationary pressures
- Stay updated on inflation trends
By staying on top of these three things, you can better protect your wealth and stay on track to achieve your long-term financial goals. We genuinely love helping people understand their finances better and help them align their values with their money. Reach out to Abacus and schedule a call today and find out how we can help turn anxiety into action.