Inflation: what is it and why it matters
If you’ve ever heard someone say something like, “I remember when a soda only cost me a dime,” there’s a big reason: inflation. Due to inflation, the price of a bottle of Coca-Cola has increased twelve-fold since its debut in 1886.
Understanding what inflation is and how it affects you can be helpful in making decisions about your money, now and in the future.
What is inflation?
Inflation occurs when the price of goods and services increases over time. The result is a decrease in purchasing power, or the value of money, over time.
Because inflation affects the prices of everything around us, it’s important to keep an eye on the evolution of the inflation rate, especially when planning what might happen next.
How to measure inflation
A commonly used measure of inflation is the consumer price index or CPI, calculated by the United States Bureau of Labor Statistics. The office measures the CPI by monitoring the average change in prices paid for a variety of goods and services, classified into eight groups: food, shelter, clothing, medical care, recreation, transportation, education and communication, and other goods and services.
There are other metrics that tell us about the history of inflation, such as the personal consumption expenditure price index. The PCE is calculated by the United States Bureau of Economic Analysis, which also prices a basket of goods and services that is different from the basket of the CPI.
You might hear about inflation described as a headline or core. Headline inflation measures total inflation over a period of time. Core inflation attempts to give a more accurate reading of inflation by excluding food and energy prices, which can fluctuate significantly on a daily basis.
You can calculate the rate of inflation by looking at the percentage change in the CPI over a period of time.
Discover our practice inflation calculator to see the impact of inflation on the value of your money.
Types of inflation
There are many types of inflation, characterized either by its cause or by its rate of increase.
Pushing costs. A common cause of inflation is when the cost of producing goods and services goes up and pushes prices up. This can happen when raw material prices or labor costs increase.
Attract demand. Another cause of inflation is when the demand for goods and services exceeds what can be produced at that time, which drives up prices.
Deflation. The opposite of inflation – a negative inflation rate or a drop in the prices of goods and services.
Disinflation. A drop in the rate of inflation or a slowdown in the rise in prices of goods and services.
Relaunch. A way to curb deflation, when a government deliberately stimulates the economy by increasing money supply or government spending – like COVID stimulus payments. Reflation can also occur when a government lowers interest rates.
Crawling. Low or moderate inflation with prices rising less than 3% per year.
Walking (trotting). Prices are increasing moderately, but the annual inflation rate remains in single digits.
Running (galloping). Prices are rising dramatically in the double digits, above 10% per year.
Hyperinflation. An extraordinary spiraling uncontrollable inflation, more than 1000% per year.
Stagflation. High inflation even in times of economic downturn.
Why inflation matters
The impact of inflation is felt throughout an economy. As prices go up, what you can buy now will go down over time. Being able to fight, or at least keep up with, inflation and maintain the purchasing power of your money is one of the main reasons for investing your money.
Consumers care about inflation because it affects costs and their standard of living. Companies carefully monitor the price of the raw materials that go into their products, as well as the wages they need to pay their employees. Inflation affects taxes, government spending and programs, the level of interest rates and more.
A low, stable or predictable level of inflation is considered positive for an economy. It signals growth and healthy demand for goods and services.
As businesses generate more goods and services to meet demand, they have to hire more workers, which usually leads to increased employment and wages. These workers then buy the things they need and need, and the cycle continues. However, when inflation becomes too high or too low, it becomes dangerous as it is difficult to control supply and demand, as well as economic growth.
This brings us to the importance of investing. Although you earn interest from the bank on the money in your savings account, the interest rate you receive generally won’t equal or even close to beating the rate of inflation. This is why it makes sense to invest your money, if you can afford it, and increase the value of that money over time. This way you can buy the same amount of goods and services in the future.
When creating a plan to meet your financial goals, it is important to allow for a realistic rate of inflation for future expenses so that you are saving enough to meet your needs.
Inflation rate in the United States
If we consider the CPI for the 30 years from 1989 to 2019, the average annual inflation rate was 2.5%. The Federal Open Market Committee, the arm of the US central bank that makes decisions about the management of the country’s money supply, targets an inflation rate of 2% over time.
The prices of different goods and services may increase at different rates. For example, the costs of education and health care are generally subject to higher rates of inflation than the average rate of inflation.
According to finaid.org, a site that offers tips, tools, and information on financial aid, tuition rates in the United States are typically more than double the general inflation rate and increase on average by about 8 % every year.
And according to the Centers for Medicare and Medicaid Services, national health spending is expected to increase at an average annual rate of 5.4% between 2019 and 2028.
How can you protect yourself against inflation
Avoid hoarding money
To make sure your money doesn’t lose too much value, it’s important to invest and not keep too much money in cash, said Tony Molina, Senior Product Specialist at Wealthfront, in an email interview. .
“The impulse to keep as much money as possible is understandable, and it can be reassuring to accumulate more in difficult situations as a buffer against unexpected events,” he said.
However, inflation means your money will likely buy less over time. Molina suggests investing the money that you don’t intend to use in the next three to five years, in order to avoid a decrease in purchasing power.
Diversify your portfolio
Another way to prepare for inflation is to have a well-diversified investment portfolio. Diversification, when you allocate your investments between asset classes (stocks, bonds, cash, real assets, etc.), various sectors and countries, helps to improve investment returns while simultaneously reducing risks, such as inflation .
Some investments are more tolerant of inflation than others or increase with inflation, said Eric Leve, chartered financial analyst and chief investment officer of Bailard, a wealth management company in San Francisco, in an e- mail.
Leve recommends including some of these natural inflation hedges in your overall portfolio to help defend against inflationary times, such as:
Real goods. Assets such as gold or real estate, which retains its value or provides pricing power, helps resist inflation. For example, sometimes landlords increase rents as inflation rises.
Stocks. Mostly stocks with proven earnings growth and low debt. Interest rates tend to rise with inflation, forcing heavily indebted companies to face higher payments.
Treasury securities protected against inflation. In times of inflation, rising interest rates have a negative impact on traditional bonds because bond prices and interest rates have an inverse relationship. Advice are a type of bond indexed directly to the CPI intended to help investors preserve their purchasing power.
Ask for help
It is important to make sure that your investments are set up to protect against inflation and there are many factors that need to be taken into account. Get a second opinion from a Financial Advisor can be useful in making sure you are on the right track and have your portfolio prepared for all seasons of different economic environments.