Everyone is talking about inflation these days – it dominates news headlines and finds its way into most conversations about the economy.
But, for many of us, this somewhat tricky economic concept could do with a little bit of explaining. What does inflation actually mean? And how can it impact your financial situation?
Below, we answer some of the most frequently asked inflation-related questions.
What is inflation?
In the simplest possible terms, inflation is what happens when prices go up and therefore the purchasing power of money goes down.
A dollar is worth fundamentally less if, overall, goods and services increase in price. You can probably remember how much you could buy for a dollar when you were a kid, and it was a lot more than you can buy now. This is because of inflation.
While there are some pros to inflation (see below), there are also several consequences to both the economy, and the individual, when prices increase dramatically and the value of money decreases. When the inflation rate rises too high, it can play a role in triggering a recession.
How is inflation measured?
There are a few different ways to measure inflation, but typically it is measured using the Consumer Price Index (CPI).
The CPI is calculated by checking the prices of an imaginary “shopping cart of goods and services,” and recording any changes.
In the US, the Bureau of Labor Statistics reports the CPI each month and has been doing so as far back as 1931. It samples about 94,000 products and services to calculate the overall change in prices. The CPI also takes into account changes in product quality and updates the “cart” to match buying trends, adding in popular new products.
The rate of inflation is the pace of which prices are rising, which is typically expressed as a percentage. For example, if a soda costs $1 and that rises by 5 cents compared with a year earlier, than soda inflation would be 5 percent. The national inflation rate is a broad measure that takes into account an overall increase in prices.
Why does inflation rise?
So, what causes inflation rates to go up? There are typically two main causes of inflation. “Demand-pull” inflation occurs when demand for products outstrips supply. This can happen for a number of reasons: when a government or central bank simply creates more money, or lowers interest rates; or, when consumers have increased disposable income and better economic stability.
This means there is fundamentally too much money around for the goods available. The result of this is an overall increase in prices, and a significant devaluation of currency.
The other main cause of inflation is known as “cost-push” inflation. In this instance, overall prices increase due to a rise in the cost of raw materials, the rising cost of wages, or the cost of manufacturing.
When this happens without an increase in demand for goods or services from the consumer, then prices go up, but wages typically don’t, leaving the consumer out of pocket.
Why is inflation high right now?
As of June 2022, the US recorded a 9.1 percent annual rise over the previous 12-month period. A rise this high has not been seen since 1981.
Steep inflation rates are impacting many economies around the globe, for a number of reasons.
The impact of the COVID-19 pandemic has helped drive up the inflation rate. Consumers are spending lots, after a long period of lockdown with limited spending opportunities. Combine this with supply chain issues as a result of lockdowns in China and other international manufacturing hubs and there is a significant disparity between supply and demand. There is, as mentioned earlier, too many dollars around for the goods available, or “demand-pull”.
Furthermore, the Russian invasion of Ukraine has created an urgent energy shortage, and drastically affected food costs worldwide. This has significantly increased the cost of food and utilities, leading to “cost-push” inflation.
The USA is battling these two key causes of inflation simulataneously.
How does a high inflation rate impact everyday life?
The main impact on an individual’s everyday life is the increase in the price of goods. Weekly grocery shopping will jump up in cost, and for consumers with less disposable income, the consequences of this can become hugely problematic. Families could be plunged into financial difficulty as a result.
Combine the increase in the price of everyday goods with stagnating wages and the nation could start to enter a cost-of-living crisis. This is typically understood to be a time when many individuals struggle to balance their income with their expenses.
What are the benefits of inflation?
The optimum rate of inflation is around 2 percent per year. This might seem suprising; surely rising prices and a decrease in the value of money is never a good thing?
In actual fact, some inflation is necessary to stimulate the economy. A little inflation encourages consumers to buy sooner. If prices are decreasing, consumers are incentivized to hold out for a better deal before making a purchase. Plus, inflation is beneficial to consumers in debt. It erodes the value of a loan or mortgage, freeing up more dollars to spend. And finally, property owners and commodity owners will see their assets increase in value, which they can then sell at a higher rate.
Most central banks agree that an inflation rate of around 2 percent promotes spending rather than saving, which boosts the economy.
The Federal Reserve oversees US inflation rates, using various tactics to both minimize volatility and keep the inflation rate at around 2 percent.
How can I protect my finances from the effects of inflation?
There are a few useful tips that could help protect your finances from the effects of inflation. The most important thing to remember is that having a savings account full of cash can be risky. If your savings account interest rate is less than the annual inflation rate, your money is technically decreasing in value.
Keeping an eye on everyday spending is another useful tip during periods of high inflation. As the cost of goods can rise at different rates and over different timelines, ensuring you are spending particularly carefully and shopping around for the best deals could help protect your finances.
Investing in the stock market is one way to try and beat inflation, although of course that poses its own risks. And, typically, diversifying your investment portfolio can help protect against steep inflation rises.
Finally, acquiring tangible assets like property or commodities could offer some protection.
What about my retirement plans?
Planning for retirement can feel daunting, and this is particularly true when considering the current rate of inflation. It's important to think about spending and budgeting, and ensure you research your pension or retirement saving plans, as there can be significant differences between private and state options
Some plans will provide cost-of-living adjustments, and therefore ensure you are protected from inflation volatility in the future. And, as mentioned previously, consider the best options to invest retirement savings to minimize any drop in value as a result of high inflation rates over time.
How can I look after the well-being of myself and my loved ones, during tricky financial times?
Financial stress can have a significant impact on mental health, and it's especially important to ensure you are keeping an eye on the well-being of any family or friends who might be struggling financially during these uncertain times. The US inflation rate is notably high, and the repercussions are being felt by many Americans across all demographics. There are a number of resources to help deal with the pressures of financial difficulties available on the Newsroom and on the New York Life resources hub.
High inflation rates can create some financial difficulties, for both individuals and the overall economy. New York Life we are committed to providing useful information to help navigate every situation we can. If you need further assistance managing through high inflation, connect with one of our financial professionals.
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