Inflation is a term used to describe an increase in the price level of consumer goods and services.
Inflation is normally expected over time and can even be a good thing for the economy. That said, it’s important to understand how this factor can impact your financial goals. Here’s what you need to know.
What Is Inflation?
On a small scale, inflation occurs when the price of a good or service increases. That can be anything from housing, groceries, utilities and medical services to automobiles, jewelry and other things. When costs rise throughout the economy, we see inflation on a larger scale, which impacts more consumers.
Economists generally expect inflation. In fact, the Federal Reserve, the central bank for the U.S., has a target inflation rate of 2% per year, and it exercises certain policies to maintain that level over time and to prevent prices from rising too quickly. Using those policies, they help avoid hyperinflation, which happens when prices spike more than 50% per month.
There are many ways experts measure inflation, but the Consumer Price Index (CPI) is among the most popular. The CPI measures price changes of a variety of consumer products that represent the market as a whole. The Bureau of Labor Statistics maintains the CPI and updates it on a monthly basis for the U.S. as a whole, as well as for different regions.
Other indexes used include the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE).
Why Is it Important to Understand?
It’s important to understand inflation because of how it impacts your purchasing power. If you have $100 today, for instance, you can purchase $100 worth of goods today. But if the economy experiences 2% inflation over the next year, you’d need $102 to purchase the same amount of goods you can buy with $100 today.
That may not seem like a lot, but it adds up over time. For example, the average price of a movie ticket in 1980 was $2.69, according to the National Association of Theatre Owners. In 2019, that average was $9.16.
In other words, with $10, you could buy three movie tickets in 1980 and have roughly a couple of dollars left over for concessions. But in 2019, you could only get one ticket, and you wouldn’t have enough cash for popcorn or candy.
In a more pressing example, let’s say you save for retirement and earn 7% per year on your contributions. In reality, if the inflation rate over that time averages 3%, your 7% earnings may really only be worth 4%. In this blog, we’ll share a few options that may help you to offset this long-term impact.
Is Inflation Always a Bad Thing?
That’s not to say inflation is always bad. Many times, it’s actually a sign of a healthy economy. Generally, inflation results from more dollars in the economy, which results in more spending. That spending naturally increases demand for goods and services, which, in turn, increases production to meet that demand.
What Causes Inflation?
There are many different factors that go into determining the price of goods and services and, therefore, inflation. Here are some of the primary drivers behind inflation:
- An increase in production costs, such as raw materials and wages.
- Strong consumer demand for a good or service.
- Increased demand for housing, which impacts other products and services that support the housing market.
- Increased government spending.
- Lower tax rates.
- Lower interest rates set by the Federal Reserve.
How to Protect Your Finances from Inflation
There’s no way to completely avoid inflation, but there are ways to offset at least some of its cost:
- Use high-interest banking products: Many banks, including SouthEast Bank, offer high-yield checking and savings accounts. Sometimes, you may even earn more when you tie up your money for a set period with a certificate of deposit.
- Prioritize retirement savings: If you’re saving for the long term, focus on using tax-advantaged retirement savings accounts. If you put all of your investment money into traditional brokerage accounts, you may end up losing money to inflation and taxes. With a 401(k) or an individual retirement account (IRA), you can get a break on the tax side of things to maximize your earnings. You can get an IRA with brokerage firms or a bank like SouthEast Bank.
- Avoid long-term fixed-income investments: If you invest money in bonds or a fixed-income annuity, the value of the fixed payments you receive over time will go down. While fixed-income investments aren’t inherently bad, try to stick to shorter-term options.
- Consider real estate: Even if it’s just owning the home you live in, home prices tend to increase steadily over time, which helps counteract the cost of inflation. Plus, you can get a fixed-rate mortgage loan through a bank like SouthEast Bank and enjoy a fixed monthly payment despite the value of those dollars decreasing over time.
The Bottom Line
Inflation is a reality that all consumers have to deal with. While, in many cases, inflation is a sign of a healthy economy, it’s important to understand its causes and impact so you can plan ahead for your financial goals.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.