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If you’ve been paying even the smallest bit of attention to the news lately, you’ve likely heard discussions of inflation. Inflation is currently at a thirty-year high as increases in spending as we return more to normal after the pandemic has led to shortages. You may be wondering how inflation affects you. Let’s take a deeper look at inflation, its effect on your income, and how it may alter your investment strategy.
Before digging into inflation’s effect on things, it is important to ensure that we are speaking the same language. Inflation is an economic construct that describes a decrease in the purchasing power of money. This occurs as there are increases in the cost of goods and services throughout the economy. Inflation, at least to some extent, is normal. In fact, most economists would note that inflation at about 2% per year is to be expected.
However, inflation can cause some problems when it increases at higher amounts. A good measure of inflation is the consumer price index (CPI). This is a figure calculated by the U.S. Bureau of Labor Statistics that measures the change in prices for a variety of goods and services. For example, over the past year, the CPI has increased by 6.2% as of October 2021, meaning that the country has experienced a large amount of inflation.
One of the most easily understood effects of inflation lies in your purchasing power. Most people operate on a fixed income, in the sense that they receive the same amount of pay each pay period. For these people, inflation can be viewed as hurting their income. This is because inflation serves to diminish the purchasing power of the dollar.
If you have $100 and prices increase, that $100 will buy less after the price increase than it would before. This is the concept of a decline in purchasing power caused by inflation. You can easily see this when looking at costs over large periods of time. For example, a new car cost $2,210 in 1950 and $37,876 in 2020.
Another thing to keep in mind when evaluating the impact of inflation on your income is the change in your income. In many careers, it is typical to receive a cost of living increase each year. The goal of this is for your salary to keep pace with inflation, maintaining your purchasing power. Additionally, many people will get periodic raises, or perhaps your income goes up when you leave an old job for a new one. In these situations, the ideal is for your change in income to increase by more than inflation, giving you more purchasing power.
Most people operate on fixed income in the sense that they receive the same amount of pay each pay period. For these people, inflation can be viewed as hurting your income. This is because inflation serves to diminish the purchasing power of the dollar.
Another important consideration when thinking about how inflation affects you is how it interacts with your investments. There is no clear-cut answer to this. Rather, it tends to vary by the type of investment. Let’s look at some common types.
Inflation tends to far outpace most savings accounts. The average interest rate on bank savings accounts for 2021 was 0.06%, a figure much lower than inflation. Thus, the money in your savings account will almost always lose value due to inflation.
Fixed investments refer to ones whose yield is fixed such as bonds or CDs. Most fixed investments return the same rate of interest per year over their lifetime. Thus, the interest earned declines in purchasing power over the length of the investment as inflation rises. Ultimately, the goal of these investments is for the yield to outpace inflation. Inflation has an even larger impact on longer-term bonds; imagine losing 6% per year on inflation for 30 years.
Inflation tends to have a positive correlation with the U.S. stock market. In other words, stocks tend to increase as inflation increases. The stock increase tends to be greater for larger companies. This makes sense when you think about it. A company’s revenue and earnings should increase at a similar pace as inflation, meaning that stock prices rise as consumer goods increase in price. It is expected that your yield will typically outpace inflation.
Real estate and other real assets such as commodities also typically have a positive relationship, increasing in value as inflation increases as well. In fact, commodities are often directly or indirectly linked to inflation. For example, oil commodities are strongly tied to energy prices. An intuitive way to think about it is the demand for these goods has not changed but the money supply has, so adjusted for inflation these assets should hold their value over the long run.
Inflation is often thought of as a negative thing, and it certainly can be. However, inflation is an economic reality. Understanding how it affects your income and investments is important. Inflation reduces the purchasing power of a dollar and can reduce your own purchasing power if your income does not grow at a rate greater than inflation. Stocks and real estate are good types of investments that can protect against potential negative inflationary effects in your portfolio.