What most people know about inflation is that it makes things more expensive. A simple definition of inflation is that it’s the increase in the cost of goods and services over a time period in either a national or international economy. It’s usually expressed as a yearly percentage, and inflation rates are often measured by a variety of indexes, including the Department of Commerce’s Personal Consumption Expenditure.
Learning a little more about the different types of inflation and how they could impact your life both positively and negatively can help you make better financial decisions, especially when it comes to protecting your money now and in the long run.
5 Positive Effects of Inflation
Despite what you might think, not all outcomes of inflation are bad. In fact, maintaining a healthy rate of inflation is good for the economy. Here are five ways inflation positively affects you.
1. Better Savings Account Rates
Investors with short-term goals might invest in a high-interest savings account if they think they would need access to their funds in the near future. If this sounds like you, your short-term savings could get a boost as increasing inflation often prompts the Federal Reserve to raise interest rates. So you could benefit from a better return on money sitting in your cash or savings account.
Learn: What is the Federal Reserve?
2. Cheaper to Travel Abroad
Inflation and higher interest rates push the American dollar higher. Yes, things cost more at home, but inflation also makes purchases in foreign countries cheaper when you pay with U.S. dollars. This includes the cost of travel, hotel and food as well as purchasing items while you’re abroad. So celebrate inflation by taking a trip outside the U.S.
Ultimate Guide: Spending Your Money in 42 Countries This Summer
3. Offsets Negative Effects of Deflation
The opposite of inflation is deflation, which results in lower prices on many things, such as grocery items. Deflation might sound good on the surface because it increases the value of your money. In reality, however, deflation leads to sluggish sales for the grocers and retailers, which in turn impacts the share price of these companies, part of our overall stock market and economy. So a little inflation to keep deflation at bay is a good thing.
In the U.S., the Federal Reserve considers inflation rates of about 2 percent per year as healthy for the economy. Two percent is the target inflation rate because it minimizes the chances of falling prices and wages, which can weaken an economy.
4. Higher Wages
As inflation pushes the price of goods and services higher, it’s also positively correlated with higher wages. A tight job market might lead to wage growth, which is seen as one of the causes of inflation. So not only do companies find they need to offer better salaries to new hires, they’ll also have to pay more attention to fairly compensating their existing employees in order to retain the talent they already have. This means if you’ve been looking around for a new job as inflation is rising, you could get paid more at a new company, but you might also have an increased opportunity for a raise.
5. Cost-of-Living Adjustments
Even if you don’t have the money to invest in stocks, gold or other assets that might be positively impacted by rising inflation, a little inflation could still benefit your financial situation. Recipients of Social Security and Supplemental Security Income could see an increase in their monthly payments when the Consumer Price Index, one of the inflation measures, goes up. This is called a Cost of Living Adjustment, and it means you’ll have a few more dollars to cover your monthly budget.
5 Negative Effects of Inflation
Along with the good, there are also some bad outcomes of inflation. Here are five ways inflation negatively impacts the economy.
1. Stuff Costs More
With inflation, prices of pretty much everything start to rise. Medical care and prices for prescription drugs could increase, and your rent could also go up. And unless your paycheck goes up at least as much as the inflation rate, you’ll be trying to pay for the increased costs of items on the same income, so inflation can be tough on the wallet — especially during hyperinflation.
Hyperinflation occurs when very high rates of inflation spiral out of control. Also keep an eye out for the phrase “core inflation,” which is an inflation measurement that excludes certain volatile markets like energy and food. On the other hand, if you see the term “all-items Consumer Price Index” note that it does include food and measures economy-wide inflation. The current inflation rate as represented by the June 2016 all-items CPI is 1 percent higher than it was in June 2015, based on reports from the U.S. Department of Agriculture’s Research Service, According to the High Plains/Midwest Ag Journal.
2. Borrowing Money Costs More
Many Americans borrow money from a lender at some point in their lives whether it’s in the form of a student loan, car loan or even a mortgage. And when inflation rises, the Federal Reserve might take it as a cue to increase rates for banks. And these rates are then, in turn, passed on to individual and business borrowers. The bottom line is that higher inflation means higher interest rates on the money you borrow — and less money in your pocket.
3. ARMs Might Have Higher Rates
Borrowers who have an adjustable rate mortgage might find that an uncomfortable effect of inflation is a higher interest rate when their mortgage is “adjusted.” This is because ARMs are usually priced according to the 10-year Treasury bill. And the rates for these long-term T-bills usually rise and fall with short-term rates set by the Fed. And that higher rate means higher ARM mortgage payments, too.
4. Hoarding in Response to Inflation
Particularly during periods of hyperinflation, people have a tendency to hoard goods. This is because the monetary value of goods might be more tomorrow than it is today, so consumers want to buy up as much as they can afford at today’s prices before the price rises. Hoarding might cause immediate shortages in food and household goods, so you could be facing long lines and empty shelves at your local shops.
5. Erosion of Long-Term Savings
For investors who count long-term, conservative investments as a significant part of their net assets, inflation can be a dirty word. This is because these traditionally safe investments, like bonds, often require investors to lock into a guaranteed rate for a long time. Inflation creates a situation where these long-term investments that pay a low interest rate have decreased buying power because inflation pushes the price of goods and services up.
How to Protect Your Money From Inflation
The best way to combat the effects of inflation is to invest in a balanced portfolio that includes some portion of long-term capital investments, like equity stocks. Ideally, these equities will increase in value over time and above the inflation rate. Though investing in more conservative investments such as bonds might be a safer way to go, some experts disagree because, in times of higher inflation, the low rate of safer investments could be below the inflation rate, which means your future buying power is slowly getting eaten away
Instead, consider protecting your money from inflation by investing in the following:
- Treasury Inflation-Protected Securities: TIPS are bonds, but they are backed by the government and their return is linked to inflation through the CPI.
- Annuities: Talk to your insurance broker about these investments that often offer an income stream that increases over time.
- Blue chip stocks: These offer dividends and capital appreciation over the long-term.
Think about how an increase or decrease in inflation could impact your life — including your grocery bill, short-term savings and retirement savings, as well as your earnings and vacation plans. Understanding how inflation works can help you make wiser financial choices, so you make the best decisions for your family.