If it feels like your dollar doesn’t go quite as far as it used to, you aren’t imagining it. The reason is inflation, which occurs when prices rise across the economy which decreases the purchasing power of your money over time. Over the past year, hopes inflation was starting to level off, the Labor Department reported the Consumer Price Index (CPI), a broad measure of everyday goods and services, in June soared even more than expected by its highest level since November 1981.
The following are some general questions to help you better understand inflation, how it affects all aspects of the economy, and the crucial impact on your investing and retirement planning efforts.
What is inflation?
Inflation is a sustained rise in overall price levels. Your dollar today will not go as far as it did yesterday.
What causes inflation?
Economists do not always agree on what spurs inflation at any given time, but generally, there are two different types you should know. Cost-push inflation and demand-pull inflation. In the short term, high inflation can be the result of a hot economy, one in which people have excess cash or credit and want to spend. Demand-pull inflation will occur as our desire to buy things increase.
How is inflation measured?
There are many ways of measuring inflation, but one of the most common measures is the Consumer Price Index (CPI), which is produced by the Bureau of Labor Statistics. The index gets its information from a survey of 23,000 businesses. The CPI reflects changes in the prices of goods and services paid by consumers on an average month based on survey results of what Americans spend their money on.
There are four major categories of purchases covered in the CPI: food, energy, cars, clothes, and services such as rent and healthcare.
How does the government manage inflation?
Inflation is generally controlled by the Central Bank and/or the government. The main policy used is monetary policy (changing interest rates). There are a variety of tools to control inflation including:
1. Monetary policy – Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
2. Control of money supply – Raising short-term interest rates discourages borrowing, decreases the money supply, slows economic activity, and reduces inflation.
3. Fiscal policy – a higher rate of income tax can reduce spending, demand, and inflationary pressures.
4. Supply-side policies – implement policies to increase competitiveness and efficiency of the economy, putting downward pressure on long-term costs.
5. Wage/price controls – controlling wages and prices could help to reduce inflationary pressures. However, they are rarely used because they are not usually effective.
How do interest rate hikes affect my finances?
Any action by the Fed to raise rates will correspond with a hike in the prime rate, sending financing costs higher for many types of consumer loans.
Short-term borrowing is the first to jump. Variable-rate debt tends to follow Fed moves within a short time usually within one to three statement cycles. Here are three things that rate increases could mean for you:
1. Credit cards. Since most credit cards have a variable rate, there is a direct connection to the Fed’s benchmark. As the federal fund rate rises, the prime rate does as well, and credit card rates follow.
Anyone with a credit card who carries a balance will soon have to shell out even more just to cover the interest charges.
2. Mortgages. Current homeowners tied to a 15-year or 30-year mortgage won’t be affected immediately by a rate hike, However, anyone shopping for a new house can expect to pay more for their next home loan. The same goes for anyone getting a loan to buy a car and student loan borrowers.
3. Car Loans. For those planning on purchasing a new car in the next few months, the Fed’s move could push the average interest rate on a new car loan past 5%. It’s already getting more expensive to buy a new or used car, as their prices have increased dramatically over the last two years. Factoring in the higher cost of borrowing, and also keep in mind there have been issues with supply not keeping up with demand.
How does inflation affect my investments?
When inflation sustains a trend of increasing prices from one year to the next, this rate creates a loss in spending or purchasing power over time. Eventually, the real value of an investment is eroded which indicates how much of a return the investments need to make to maintain a specific standard of living.
Your real rate of return is the return on your investments minus the inflation rate. So, if your income doesn’t increase by at least the same rate of inflation, you will not be able to purchase as many items you once used to.
One of the primary reasons most workers place money into stocks, bonds, and mutual funds is to keep their savings safe from the effects of inflation. When inflation is high enough, individuals often convert their liquid assets into interest-paying assets, or they spend the liquid assets on consumer goods.
Inflation can have a significant impact on your portfolio over time. Consider taking steps that may help your investments against inflation such as working with a financial professional and diversifying your portfolio. Keeping an appropriate amount of your retirement savings allocated properly can help offset inflation risk.
Heartland Retirement Plan Services are offered through Dubuque Bank and Trust Company. The information provided herein is general in nature and is not intended to be nor should be construed as specific investment, legal or tax advice. The factual information has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Heartland Retirement Plan Services makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, it. Products offered through Heartland Retirement Plan Services are not FDIC insured, are not bank guaranteed and may lose value, unless otherwise noted.