What is inflation?
Inflation is a hot topic these days. After a tumultuous few years, we’re seeing signs of stabilization, but make no mistake: inflation is here to stay. Knowing what inflation is, how it’s measured, and what you can do about it is key to managing your finances and staying ahead of rising costs.
What Is Inflation?
At its core, inflation is the rate at which prices for goods and services rise over time, reducing the purchasing power of your money.
For example, if a cup of coffee costs $1.85 this year and $2.00 next year, that price increase reflects inflation. The most common way inflation is measured is through the Consumer Price Index (CPI), which tracks the cost of a "basket" of everyday goods like milk, bread, and other essentials.
The Federal Reserve aims for an inflation rate of about 2% per year. While no one likes higher prices, some inflation is necessary to accommodate a growing population and economy.
Why Does Inflation Matter?
Inflation erodes purchasing power, meaning your money buys less over time. This can have serious consequences:
Savings lose value if they don’t grow at or above the inflation rate.
Living costs increase, making it harder to afford everyday expenses.
Retirement planning becomes trickier, especially if inflation is higher than anticipated.
How to Protect Yourself from Inflation
The good news? There are strategies to safeguard your finances and even take advantage of inflation:
1. Money Market Mutual Funds
These funds invest in low-risk, short-term assets and usually offer higher returns than traditional savings accounts. They can help your money grow while remaining relatively safe and accessible.
2. Treasury Inflation-Protected Securities (TIPS)
TIPS are bonds specifically designed to keep pace with inflation. Their value adjusts as inflation rises, preserving your purchasing power. While they aren’t the most liquid option, they’re a solid inflation hedge.
3. Invest in the Stock Market
Historically, the stock market has outpaced inflation over the long term. By investing in a diversified portfolio, you can grow your wealth as the economy expands.
4. Real Estate
Land is finite, and real estate often appreciates over time, making it a strong inflation-resistant asset. However, real estate isn’t liquid, so it’s best for long-term investments rather than emergency funds.
Understanding Nominal vs. Real Returns
When evaluating returns, it’s important to differentiate:
Nominal returns are the raw numbers, like a 7% gain on an investment.
Real returns account for inflation. For example, a 7% nominal return in a year with 8% inflation actually results in a -1% real return, meaning you lost purchasing power.
Be cautious of advertisements boasting high returns—they may not account for inflation, which can distort the true picture of your investment’s performance.
Types of Inflation
Not all inflation is created equal. Here are some common types:
Hyperinflation: Extremely high, uncontrolled inflation (e.g., 50%+ monthly) that can devastate economies by rendering currencies nearly worthless.
Stagflation: A mix of high inflation and stagnant economic growth, often accompanied by rising unemployment.
Deflation: The opposite of inflation, where prices fall over time. While it sounds beneficial, deflation increases the real value of debt, which can discourage borrowing and spending.
How Inflation Is Calculated
Inflation is typically calculated as a percentage change in the Consumer Price Index (CPI):
Inflation Rate=(New CPI−Old CPIOld CPI)×100\text{Inflation Rate} = \left( \frac{\text{New CPI} - \text{Old CPI}}{\text{Old CPI}} \right) \times 100
For example:
If coffee increases from $1.85 to $2.00, the inflation rate is:
2.00−1.851.85×100=8%\frac{2.00 - 1.85}{1.85} \times 100 = 8\%
Inflation’s Impact on Debt
One silver lining of inflation is its effect on debt. Inflation reduces the real value of what you owe, which benefits borrowers. However, this is small comfort when milk prices and other essentials continue to climb.
The Role of the Federal Reserve
To combat inflation, the Federal Reserve raised interest rates significantly during 2022–2023. While this helped stabilize prices, interest rate decisions will continue to impact everything from mortgage rates to bond yields. Staying informed about these changes is critical to making sound financial decisions.
The Bottom Line
Inflation is an inevitable part of life, but understanding it and taking steps to protect your finances can help you stay ahead. By leveraging tools like money market funds, TIPS, and strategic investments, you can safeguard your purchasing power and ensure your financial goals remain on track—even in the face of rising prices.
In the face of inflation, we have the expertise to guide you to financial security and the tools to manage your assets for a prosperous future. From budget management to estate planning to investment accounts, we can help you move towards the financial future you’re looking for. Book a call today and take the first step towards prosperity and security. You can’t afford to lose another day to wondering if you have the tools and path you need to get there, let us guide you.