How Inflation Works and What It Means for Your Wallet

Most of us have a general idea of ​​what inflation means: things get more expensive. Of course, inflation is a little more complicated. It plays a pretty important role in your day-to-day finances, from your income to the cost of milk and how much you make from your retirement savings.

What is inflation and how to measure it

Inflation is pretty simple. It is simply the rate at which the value of goods and services rises and, in turn, the decline in the value of the dollar. For example, your latte is now $ 3.50 instead of $ 3.25, which means your dollar is buying less latte. It’s the same old latte, but now your dollar is buying less, so your dollar has less value.

We measure inflation using a metric called the consumer price index or CPI. The CPI takes a basket of goods and services, from medical expenses to food and travel expenses, and averages them to give you a general idea of ​​how prices change. When the CPI rises, it means inflation is happening. The Bureau of Labor Statistics shows how the CPI has changed over the years :

You can see that the US CPI has not increased much over the past year. In fact, he fell quite a bit. You might be thinking, ” This is nonsense.” Why, then, are my balls so expensive? But keep in mind: CPI is the average of a range of different goods and services, not just food. Oil prices fell sharply in 2014 and this plays a huge role in the overall CPI, as you can see in the blue line on the chart. Take away food and energy (that’s the red line) and the CPI is still pretty static.

As you can imagine, since the CPI has remained unchanged, this means that inflation has not increased much either. In 2014, inflation in the United States was 0.4%, and at the end of 2015 it was 0.5%. Your eggs may be more expensive, but in general, you pay almost the same amount for groceries as you did a couple of years ago.

How inflation affects your wallet

Most of us tend to think of inflation as bad. As Investopedia writes :

It is easy for most people to feel the impact of rising cost of living in their daily lives. But rising prices hit the lower and middle classes especially hard. Higher costs for food, gas, and utilities mean less money is left after paying for these essentials, leaving little for savings or discretionary spending . To compensate for rising prices, consumers tend to buy less, switch to less expensive substitutes, or drive further in search of bargains.

In short, when inflation rises, we feel tension. We are looking for ways to be leaner . We are looking for great deals . So when inflation is slow, as it has been for the past couple of years, the general consensus is usually that it’s great. The gas is cheap! Food prices have not gone up much! And in the short term, that’s a good thing. This means that we don’t pay more for things, which means that the money in our wallet is more valuable, at least when it comes to spending.

Therefore, it is logical that inflation simply burns us up. This means things are getting more expensive, and who wants to pay more for them?

Why it’s important to keep up with inflation

If your savings plan is to simply hide your money under the proverbial mattress, you are effectively losing money during inflation because inflation is driving down the value of your dollar. Your savings do not bring interest, so you are not keeping pace with inflation.

For this reason, slow inflation is good news for your savings account, especially these days when interest rates are ridiculously low. The lower the inflation rate, the more you earn from your interest. Suppose you have a high-yield (I use the term loosely) savings account with a bank like Ally. You earn 1%, which is not much, but at least you still beat inflation in 2015 when it only climbed to 0.5%.

By the same logic, inflation is also a good reason to start investing and save for retirement. The simple dollar puts it this way:

Let’s say you earn $ 40,000 a year and thirty years before retirement. As a simple rule of thumb, you figure that you will need $ 1 million in retirement account to retire. Not so fast. In fact, you are calculating this million dollars without thinking about inflation. The truth is, at 4% annual inflation, you will need $ 3.24 million in thirty years to equal today’s $ 1 million … Every time you hear an inflation report remember that this is a call for you to invest. for your pension.

Some will scoff at the idea that investing helps beat inflation because the stock market has seen a significant downturn lately. But retirement savings are not based on “recent times”, but on the long term. And in the long term, the stock market has always bounced back and, on average , brought in about 6-7% of profit over time.

But if that still sounds too risky for you, there are even special investments designed to help you cope with long-term inflation. They are called inflation-protected Treasury securities . This is a low risk investment that is paid out twice a year and grows in line with the CPI. You won’t make a fortune from them, but at least you will retain the value of your dollar.

Inflation keeps balance

We enjoy ultra-low gas prices, but in the long run, that’s not all good . Most economists agree that inflation is a necessary evil. And in fact, this is not entirely evil; it keeps our economic system in balance. It also creates jobs. In his book Man vs Markets, Economics Explained, Plain and Simple , Marketplace editor Paddy Hirsch explains:

But inflation is not all that bad. In fact, governments are very fond of inflation – in moderation. Inflation can devalue existing currencies a little, but this can be offset by the fact that there is a lot more money flowing into the system: money that can be spent, or invested, or built, or even hired more employees. Thus, in moderation, inflation can help people maintain employment.

This is the basic theory behind the Phillips curve , which essentially states that there is an inverse relationship between unemployment and inflation. In theory, if inflation stays the same, that means businesses don’t make that much, which means they don’t pay workers that much or fire them entirely because the business isn’t growing. By the same logic, if inflation rises, both spending and employment will increase. If the company you work for makes more money, you are more likely to get promoted.

Not all economists agree with the Phillips curve, but it is clear that there is some relationship between wages and inflation, which is why the Federal Reserve has an inflation target of 2%. The Fed is trying to control inflation by adjusting the federal funds rate – an interest rate that affects credit cards, loans, and savings rates. In their opinion, 2% is the golden mean between excessive price increases and the risk of deflation. In their own words :

The Federal Open Market Committee (FOMC) believes inflation at 2% … is most in line with the Federal Reserve’s mandate to ensure price stability and maximum employment in the long term … lower inflation will be associated with an increased likelihood of falling into deflation which means that prices and possibly wages are falling on average – a phenomenon associated with very weak economic conditions. Having even a small level of inflation reduces the likelihood that the economy will experience harmful deflation if economic conditions weaken.

Lower prices mean companies suffer, so people lose their jobs or stop getting paid, so they stop spending money. Or worse, they run out of money and start defaulting on loans and mortgages. Then the banks suffer and the economy goes into a crash. In a nutshell, this is deflation, and as an example of deflation, this is what happened in Japan in the nineties.

After several asset bubbles burst in Japan, the country experienced a huge economic stagnation that eventually led to deflation. Investopedia sums up Japan’s deflationary history :

From 1991 to 2003, the Japanese economy, as measured by GDP, grew at just 1.14% a year, which is much lower than that of other industrialized countries … Obviously, deflation is causing a lot of problems. When asset prices fall, households and investors hoard cash because tomorrow the money will be worth more than it is today. This creates a liquidity trap. When asset prices fall, the value of secured loans falls, which in turn leads to losses for banks. When banks fail, they stop lending, creating a credit crunch. In most cases, we think of inflation as a very serious economic problem, which may be, but re-inflation of the economy may be exactly what is needed to avoid prolonged periods of slow growth like Japan experienced in the 1990s.

In short, inflation is not always a bad thing. While low prices provide short-term benefits, we need them in the long term. Otherwise, it can lead to more systematic and serious long-term problems. As with most things in life, it all comes down to balance.


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