Inflation is the rate of change in prices. Rising inflation means you have to pay more for the same goods and services. This can help you in the form of income inflation or asset inflation, such as in housing or stocks, if you own the assets before prices rise, but if your income doesn’t keep pace with inflation, your buying power declines. Over time, inflation increases your cost of living. If the inflation rate is high enough, it hurts the economy.
The effect depends on the type of inflation. For example, walking inflation is 3% to 10% per year. Creeping inflation is milder than walking inflation while running inflation implies a more aggressive rise in prices that could be a precursor to hyperinflation.
Rising prices may be an indication of an economy growing very fast. People buy more than they need to avoid tomorrow's higher prices fuels demand for goods and services. Suppliers can't keep up. More importantly, neither can wages. As a result, everyday goods and services are priced out of most people's reach.
- Inflation raises prices, lowering your purchasing power.
- Inflation also lowers the values of pensions, savings, and Treasury notes.
- Assets such as real estate and collectibles usually keep up with inflation.
- Variable interest rates on loans increase during inflation.
Inflation doesn't affect everything the same way. For example, gas prices could double while your home loses value. That's what happened during the financial crisis of 2008. Home prices deflated, falling nearly 20%. Meanwhile, inflation occurred in oil prices. They reached an all-time high of $128 a barrel in July 2008. Since oil prices influence gas prices, the cost of gas rose above four dollars a gallon in some parts of the United States. Driving to work became even more expensive and even stressful, at a time when many workers were worried about keeping their jobs.
Gas prices rose to similar levels, breaching the $4-a-gallon mark in some parts of the country in October 2021. The U.S. economy which was recovering from the pandemic-related slowdown saw the consumer price index increase to 6.2%, its highest level since November 1990.
When Inflation Helps the Economy
Sometimes inflation is good for the economy. When it's mild, inflation has a healthy side effect. Once people start to expect inflation, they spend now rather than later because they know prices will be higher in the future. Consumer spending drives economic growth.
In fact, the Federal Reserve sets an inflation target. It wants a healthy core inflation rate of 2%, which takes out the effect of food and energy prices. The central bank wants a little inflation, which also leads consumers to believe prices will continue rising.
Effect on Retirement Planning
Inflation can be bad for your retirement planning. Your target amount must keep rising to pay for the same quality of life. In other words, your savings will buy less as time goes on.
To be prepared for inflation during your retirement, save more than you think you will need. It's also important to begin saving as soon as possible in order to benefit as much as you can from compounding interest.
Impact on Treasury Bonds
Monitoring inflation is important if you hold bonds or Treasury notes. These fixed-income assets pay the same amount each year. When inflation rises faster than the return on these assets, they become less valuable. People rush to sell them, further depreciating their value. When that happens, the U.S. government is forced to offer higher Treasury yields to sell them at all. As a result, most mortgage interest rates increase.
Higher rates lower the value of your investments. They also increase the cost to the federal government of financing the U.S. debt. The interest on the national debt rises. The additional budget expense needs to be offset by a cut in the discretionary budget or an increase in taxes. Otherwise further deficit spending will occur. All of those are contractionary fiscal policies that slow economic growth, which translates into a lower standard of living.
When Inflation Is Catastrophic
Inflation that reaches 50% a month is called hyperinflation. It occurs when the government essentially prints money without regard to the inflation rate. It happened in Germany in the 1920s (highest monthly inflation rate of 29,525.71%) and Zimbabwe in the 2000s (last recorded monthly inflation rate of 2,600.2% in 2008). Hyperinflation could lead to a U.S. economic collapse.
If inflation ever approaches hyperinflation, your best defense is to buy gold or any currency that isn't pegged to the dollar.
Inflation's Winners and Losers
If you have a fixed-rate mortgage, you'll benefit from inflation because the value of your monthly mortgage payments will decrease over time. Your payment might be a fixed $1,500 per month for 30 years, but since the value of that $1,500 decreases over that 30-year period, it will feel like you're paying less. That's assuming your income has grown along with the rate of inflation.
Investing in the stock market is another way to benefit from inflation.
If inflation increases the price of a widget every year, the value of the company that makes the widgets also is likely to increase every year. So holding stock in that company is a good way to protect yourself from being negatively impacted by inflation.
Not everyone benefits from inflation, though. Anyone carrying debt with a variable interest rate is likely to see their minimum payments increase as inflation rises. This is the case most often with high credit card debt, but it also applies to variable-rate mortgages.
Inflation also negatively impacts those who are in the market to buy a house. The prices of homes are likely to rise right along with the rate of inflation.
Frequently Asked Questions (FAQs)
Why does inflation occur?
The two fundamental causes of inflation are an increase in demand or a decrease in supply. There are numerous economic conditions and factors that can move either of these needles, though, so it's not quite that simple to pin down the exact cause of inflation. At any given time, inflation can be a result of a mix of market and policy forces.
How do you hedge against inflation?
Certain asset classes do a better job of hedging against inflation than others. These include gold and other precious metals, Treasury inflation-protected securities (TIPS), floating-rate bonds, some stocks, real estate, and certain commodities. Including some of these items in your portfolio can help you keep pace with inflation over time.
How does inflation affect the stock market?
The net results of inflation will depend on the various factors that are causing it. Typically, though, it will lead to rising stock prices as companies adjust their operations to higher costs in the supply chain or production process. In some cases, this can cause volatility and price swings. Before you make any decisions about buying or selling stocks during a period of high inflation, consult with a financial advisor.