Inflation is near its highest rate in four decades, with prices up 8.3% as of April compared to the same point in 2021. How does inflation happen, and what can you do to protect against inflation within your personal finances? Let’s take a closer look.
1. What is Inflation?
Inflation is an overall trend of increasing prices. When inflation affects an economy:
Your money doesn’t go as far. Let’s say you used to spend $150 per week to gas up your car and shop for groceries. As the years went by, these purchases rose to $200. Because they cost more, each of your dollars is effectively worth less.
Prices rise across the board. Inflated prices in one sector or industry don’t necessarily spell trouble for the economy (or your wallet). But a widespread rise in prices ultimately weakens everyone’s spending power.
Some prices are affected more than others. How much inflation affects your finances may depend on what you’re purchasing. While some prices have held steady, you probably felt the pain of inflation if you recently bought a car, put fuel in your tank or booked a flight. Your grocery or energy bills may have gone up too.
2. Why Does Inflation Happen?
Primarily, inflation happens when the demand for a good or service exceeds the available supply (called “demand-pull” inflation), which causes prices to rise. Also, if it becomes costlier for a business to make a product or deliver a service, the company may raise prices to factor in its added costs and make sure it still turns a profit (this is known as “cost-push” inflation).
Right now, many factors causing inflation are connected to the pandemic. For one thing, consumers may have been holding onto more cash. This is because of government stimulus checks they received as well as the fact that they had fewer opportunities to spend their money because of restrictions on businesses during the height of the pandemic. Shoppers are ready to spend money on an increasing variety of goods – but sellers are struggling to meet this pent-up demand.
Plenty of other issues are also driving up prices, such as the war in Ukraine, rising energy costs and a tight labor market. Shipping costs escalated because of backups at ports and other distribution hubs and a scarcity of truck drivers. On top of this, as costs have risen at each link in the supply chain, some companies have taken the opportunity to increase their prices beyond what’s required by their higher expenses.
3. How Is Inflation Measured?
Inflation is gauged in several different ways. The best-known method is the Labor Department’s Consumer Price Index (CPI), which tracks prices for a limited selection of goods and services. But this index doesn’t measure certain types of spending. The Personal Consumption Expenditures Price Index, or PCE, paints a more complete picture by looking at a wider set of numbers as well as feedback from businesses.
4. Is Inflation Harmful?
It depends on the reasons for inflation, as well as its severity. Consider this example. If a popular brand of candy gets more expensive, this could mean that consumers have more disposable income to spend on their favorite sweets, so the product is flying off the shelves. That’s good news for the candy company and the economy.
On the other hand, if the candy’s price goes up because bad weather hurt agricultural production – making food ingredients more expensive – this would be a bad form of inflation. The extra cost of making the candy is passed on to consumers without any related economic benefit.
5. How Does Inflation Affect Borrowers?
You can expect borrowing costs to rise during times of fast inflation. The Federal Reserve helps regulate the cost of borrowing money. It uses its ability to set higher interest rates as a tool to help slow the economy and keep inflation in check.
If you’re paying back a mortgage, auto loan or other debt, you may actually benefit from any inflation that’s happened since you took out the loan. That’s because each dollar you pay back is worth less than when you borrowed it. To see a meaningful boost to your finances, your income must have risen along with inflation.
6. How Does Inflation Affect Investors?
Inflation impacts the value of many different asset categories, but cash is especially vulnerable. That’s because the money you keep in a low-yielding savings account won’t grow fast enough to keep up with inflation. For many people, higher-return investments like stocks and bonds can be a helpful source of inflation protection.
7. What Can I Do?
Economists expect our current high inflation rate to relax, though it’s expected to stay above pre-pandemic levels through next year. In the meantime, here are two ways to keep your finances in shape as prices rise.
- Keep your savings growing. Putting your money in higher-yielding investments that fit both your goals and risk tolerance can help protect the value of your financial portfolio. However, you should still keep some money safe in a federally insured savings or money market account, where it’s easy to access for emergencies.
- Fine-tune your budget. Adjust your spending, particularly for discretionary expenses like dining out, to fit your budget to changing prices. You can always adjust your spending limits again if needed. The important thing is that your expenses are met and you’re still setting aside money in your savings.
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