Have you ever wondered why the items you buy cost so much more than they used to years ago? From rent to groceries, everything goes up in price over time. Why? Surely you have heard the word inflation, but do you actually understand what it is? What is inflation and how does it affect your money? Here I share with you the answer to these questions.
What is inflation?
Inflation is an economic concept used to describe a rise in average prices in an economy.
When inflation is high it means that products are more expensive and therefore we need more money to purchase them. Inflation reduces the value of our money and purchasing power, because we can buy less than we used to with the same amount of money.
It is important to observe that not all price increases are due to inflation. Other factors also contribute to a rise in prices, such as a change in demand, market or even severe weather (depending on the sector).
How does inflation affect my money?
Inflation makes your money lose value and decreases your purchasing power. This means that if your salary stays the same, over the years you will be able to buy less and less.
For example, the value of USD100 in 1960 is equivalent to about USD902.21 today. This shows an average inflation rate of 3.67% per year between 1960 and today, or a price increase of 802.21% in total. If you got paid 100 dollars in 1960 you would be able to afford a lot more than if you got paid 100 dollars today.
When inflation is high it impacts the whole economy. It increases costs and reduces people’s purchasing power. Initially, people might tend to spend their money quickly before prices rise. However, as prices rise and people can’t afford to make purchases the whole economy suffers.
Inflation is not necessarily good or bad. Both very high and very low inflation are considered bad for the economy. Very high inflation can wipe people’s savings and cause great instability. Very low inflation can slow economic and wage growth. Most economists advocate for an optimal rate of inflation of around 2% per year.
As an investor, it is essential to understand the effects of inflation.
High inflation means that your money is losing value. This works for both your spending money and your investments. If you are a saver but not an investor, over time you will lose money. Inflation will erode the purchasing power of your savings.
It is important to make sure that the returns you are earning on your investments are higher than the inflation rate, otherwise you will be losing your hard-earned money.
The inflation rate in the US in June 2021 is 4.99%, and the average interest rate in a high yield savings account is between 0.4% and 0.5%. This is a big difference. Make sure to account for inflation when planning your investments.
On the other hand, if you are a borrower inflation can work in your favour. When adjusted to inflation your debt will shrink over time. This can be a good thing for business owners or real estate investors who use leverage.
What causes inflation?
Inflation is caused by an increase in the money supply in an economy. This can be controlled by the monetary authorities in different ways, such as printing more money or open-market operations.
Inflation can be driven by higher demand for products and services. The increase in money supply causes demand to increase faster than production, which leads to price rises.
It can also be driven by an increase in production costs, which pushes up the prices of finished goods.
Inflation can also it can be built-in. When prices rise, wages need to rise too, which results in even higher product prices.
The Consumer Price Index (CPI) analyses the prices of a basket of goods and services. Changes in this index associated with cost of living are a popular way to identify inflation. Other indexes are used too, such as the Producer Price Index (PPI) and theWholesale Price Index (WPI).
How to mitigate the effects of inflation?
We as individuals are not in charge of monetary policies and can’t directly impact inflation. However, there are things we can do to mitigate its impact in our finances. Here are some ideas:
- Do not hold too much cash. Make sure to invest your savings.
- If you need high liquidity to make a purchase in the near future or for your emergency fund look into a high yield savings account. It is not the most optimal place for your money, but it is certainly better than holding cash.
- Diversify your investments. It might be a good idea to invest in commodities, properties and other assets that tend to go up in value in times of inflation.
- Review your long term fixed-interest investments. If you receive $1000 in interest every year from your investment, remember that those $1000 will not be worth the same in 20 years.
- If you choose to invest in bonds, you can opt for Treasury Inflation Protected Securities (TIPS), which are government bonds that offer protection against inflation (the principal is adjusted based on the Consumer Price Index). Understand that high interest rates tend to drive down the value of bonds, so take this into account when choosing your investments.
- If you believe inflation is rising, it might be a good idea to fix some of your expenses, such as your mortgage.
- Adjust your your lifestyle to cope with higher cost of living. You might have to temporarily make different consumer choices in order to cope with the higher costs.
I hope this post has been useful to you. It is essential to understand inflation and how it affects your money and investments. It will help you be prepared and make better choices.