Your Income and the Inflation Rate

If you’ve been paying even a little attention to the news lately, you’ve probably heard plenty of discussion about inflation.

Inflation recently reached a 30-year high, as increased consumer spending during the post-pandemic recovery contributed to widespread shortages.

You may be wondering how inflation affects your own finances.

Let’s take a closer look at what inflation is, how it impacts your income, and how it may influence your investment strategy.

What Is Inflation?

Before discussing its effects, it’s helpful to define inflation.

Inflation is an economic concept that describes a decline in the purchasing power of money. As the prices of goods and services rise throughout the economy, each dollar buys less than it did before.

A modest amount of inflation is generally considered healthy. In fact, many economists view an annual inflation rate of around 2% as normal.

Problems arise when inflation accelerates beyond that level.

One of the most common measures of inflation is the Consumer Price Index (CPI), calculated by the U.S. Bureau of Labor Statistics. The CPI tracks changes in the prices of a broad basket of goods and services.

As of October 2021, the CPI had increased 6.2% over the previous year, indicating a significant rise in inflation.

How Inflation Affects Your Income

One of the easiest ways to understand inflation is through its effect on purchasing power.

Most people earn a relatively fixed paycheck during each pay period. If prices rise while your income stays the same, your money simply doesn’t go as far.

For example, if you have $100 and prices increase, that same $100 buys fewer goods and services than it did before.

You can clearly see this effect over long periods of time.

For example:

• A new car cost approximately $2,210 in 1950.
• By 2020, the average price had increased to $37,876.

Fortunately, income doesn’t always remain static.

Many employers provide annual cost-of-living adjustments (COLAs) designed to help salaries keep pace with inflation. Others provide merit raises or promotions that increase earnings over time.

Ideally, your income should grow faster than inflation, allowing your purchasing power to increase rather than decline.

How Inflation Affects Your Investments

Inflation also influences investment performance.

Its impact depends largely on the type of asset you own.

Savings Accounts

Savings accounts generally perform poorly during periods of high inflation.

The average savings account interest rate in 2021 was approximately 0.06%, far below the inflation rate.

As a result, cash held in savings accounts typically loses purchasing power over time.

Fixed-Income Investments

Fixed-income investments include assets such as:

• Bonds
• Certificates of Deposit (CDs)

These investments generally pay a fixed interest rate throughout their life.

When inflation rises, the purchasing power of those fixed interest payments declines.

Long-term bonds are especially vulnerable because inflation compounds over many years.

Stocks

Historically, stocks have often shown a positive relationship with inflation.

As prices increase throughout the economy, companies generally generate higher revenues and earnings, which can support higher stock prices.

Larger companies, in particular, often have greater pricing power and may be better positioned to pass higher costs on to consumers.

Over the long run, stock market returns have generally outpaced inflation.

Real Estate

Real estate and many commodities have also historically performed well during inflationary periods.

Many tangible assets naturally appreciate alongside inflation because replacement costs and underlying commodity prices increase.

For example, energy commodities such as oil are closely tied to inflation through higher fuel prices.

One way to think about it is this:

Demand for the underlying asset may remain relatively unchanged, but as the money supply expands, the nominal value of real assets often rises as well.

Final Thoughts

Inflation is often viewed negatively—and for good reason—but it is also a normal part of a growing economy.

Understanding how inflation affects both your income and your investments can help you make better financial decisions.

Inflation reduces the purchasing power of money, meaning your income loses value unless it grows faster than prices.

At the same time, certain investments—particularly stocks and real estate—have historically provided some protection against inflation by increasing in value over the long term.