Everything You Need to Know About Inflation
It’s almost impossible to turn on the news or scroll the headlines today and not be confronted by rising inflation. With an inflation rate of 8.5% in July, it is easy to see why.
The government typically works to target 2% inflation to keep price changes low while encouraging economic growth. So the high inflation rates we’ve seen in the past few months may seem concerning.
In order to truly understand inflation, what’s causing it, what’s being done about it, and most importantly how it might affect you, it’s crucial first to understand what inflation is. So, here’s a quick primer on everything you need to know about inflation.
- Current inflation is high, which means our purchasing power has been diminished.
- While the Federal Reserve is working to combat rising inflation rates by increasing interest rates, there are also things you can do to look out for your budget.
- It’s more important than ever to know what your essential expenses are and to find ways to save where you can.
- It’s also important to keep your money working for you. There are options like High Yield Savings Accounts and Series I Bonds that might help you as you continue to work towards your savings goals.
- Be aware of what you’re spending and how your purchasing power may be changing, and you’ll be able to keep an eye on inflation while still budgeting, saving, and reaching your goals.
What is the meaning of inflation?
Investopedia defines inflation as “a rise in prices, which can be translated as the decline in purchasing power over time.” Put simply, inflation is the decline in your ability to purchase the same goods and services over time as the price of those goods and services rises.
The reduction in purchasing power can put stress on your budget and make tight financial situations even tighter.
The government calculates inflation by comparing the current price of a set of goods and services to their previous prices. The goods and services used to offer a wide cross-section of things that consumers might buy to more accurately reflect the true rising costs consumers face.
Comparing the same set of goods and services over time allows the government to get a sense of what is happening to prices in the overall economy.
What’s Driving Current Inflation?
Inflation can be impacted by consumer demand throughout an economy and also through supply-side factors. The current inflation we are experiencing is being caused by issues in both of these areas.
There are three main factors causing current inflation:
- Inflation is being driven up by an increase in demand from consumers. During the first part of the global pandemic, consumers mostly stayed home. Being place-bound changed expenses for some, eliminating things like commuting or childcare costs. As costs and behaviors shifted, some individuals found themselves saving money. Now things have shifted again, people are going out more, and life is getting somewhat back to normal. This shift has caused an increase in demand for goods and services which has caused prices to rise.
- Supply has also been affected by the pandemic. Due to global lockdowns, factory closures, labor shortages, and supply chain issues, supply for goods has not managed to keep up with demand. As supply has failed to keep up with demand, we’ve seen an increase in prices throughout the economy.
- We’ve also seen a shift in spending from goods to services. During the start of the pandemic, most services were inaccessible. But now, as things are opening back up, people are shifting their spending towards services and experiences. People are returning to restaurants and starting to travel and participate in other events again. Prices for these things have started to increase due to limited supplies and increases in labor costs.
These three factors have combined to create the current inflationary environment. But just because we’ve experienced a few months of higher-than-normal inflation doesn’t mean nothing can be done.
What’s the Government Doing to Help Inflation?
The government is working to reduce inflation through its financial regulation process. In the US, our financial regulation comes through the Federal Reserve. One of the ways the Federal Reserve is currently working to combat inflation is by raising interest rates.
When the Federal Reserve talks about raising rates, it is referring to the interest rates at which banks can borrow short-term loans from one another. When it becomes more expensive for banks to borrow money, they, in turn, raise the interest rates that consumers and businesses face.
This means the interest rates an individual might be offered for a car loan, mortgage, or credit card will start to go up. This upward pressure on the cost of borrowing can slow economic activity so that fewer people are willing to borrow and also spend money. So businesses will start investing less, and consumers will start spending less. As demand starts to fall, so should inflation.
How Does Higher Inflation Affect You?
Understanding how inflation works and what the government is doing about it is important. But what’s more important is understanding how inflation might affect you personally.
The biggest impact inflation will have on you is it will reduce your spending power.
As the prices of goods and services you buy go up, the value of your money remains unchanged. So each dollar you spend no longer buys as much. This can make it difficult to take care of your regular expenses. It can also mean your essential expenses take up a larger portion of your budget. This leaves less money to spend on your non-essential expenses or to save and invest.
Another way inflation might affect you is by making it more expensive for you to borrow money.
As the Federal Reserve raises interest rates for banks, banks raise rates for consumers. When you borrow money at a higher interest rate, it means that over the life of the loan, you will pay back more interest than if you’d borrowed the same amount at a lower rate. This makes taking out a loan more expensive. The increase in interest rates can also cause your monthly payment to increase. So, if you are taking out a loan in the near future, it may be a little more expensive to borrow the money.
Protecting Yourself from Rising Inflation Rates:
When faced with rising inflation, there are a few things you can do to protect yourself and your money.
- Be sure you know your key expenses. Knowing your essential expenses will help you know what you must cover each month. To identify your essential expenses, take a look at your last three to six months of bank statements. Make a note of all of the expenses you have to pay in a month to keep your life moving. This will include things like rent/mortgage payments, loan payments, groceries, utilities, phone and transportation expenses, insurance costs, medical costs, and childcare costs. Make a list of your essential expenses and how much they are each month, then be sure to cover these costs first as prices rise. If there is still money left in the budget once these are covered, you can add in your non-essential expenses, saving, and investing.
- Be mindful of how and where you shop. You might find that generic or store brands are cheaper and work just as well as the name brands you usually buy. Making this switch, along with price comparing the stores in your area and shopping at the cheapest one, can help you keep costs more reasonable during periods of inflation.
- Make sure your money is working hard for you. It’s clear that one of the biggest issues with inflation is it erodes your spending power. So, one of the best things you can do to combat inflation is to make sure your money is still working hard for you.
Here are 2 ways you can make your money work for you, especially during periods of high inflation:
- Open a High Yield Savings Account (HYSA). A HYSA is a savings account that has a higher interest rate. You may be able to find an account like this locally, but typically the best accounts are offered online. Opening a HYSA and using it to hold your emergency fund or money towards your other goals is a great way to combat inflation. While a HYSA likely won’t have an interest rate that keeps up with inflation, the rates you find on accounts like this will be higher than a normal savings account.
A normal savings account might have an interest rate of 0.01%, while you may be able to find a HYSA with an interest rate between 1.5% and 2% currently (depending on the bank).
Having your money in a HYSA can help it work harder for you, especially during times of higher inflation. It’s also key to note that a HYSA can be beneficial because often as the Fed raises interest rates, your bank will raise interest on your savings as well. If you open a HYSA, be sure you understand the terms of the account and any requirements, like a minimum initial deposit.
- Invest in Series I bonds. Series I bonds help your money grow during times of inflation. Series I Bonds are securities issued by the federal government that are made to track inflation.
These bonds have an interest rate made up of two components, the first is the interest on the bond, and it is fixed for the life of the bond. The second component is a variable rate that is built in as inflation protection. This portion of the interest rate is adjusted each May and November depending on how inflation has changed. These bonds can be a good way to save some funds for the future, especially during times of high inflation. They don’t necessarily earn a ton of extra interest, but with the inflation protection and a small amount of interest built in, your purchasing power isn’t eroded.
There are a few key things to know if you are considering purchasing Series I Bonds.
First, an individual can buy a minimum of $25 per calendar year of Series I Bonds and a maximum of $10,000 for electronic bonds (paper bonds have a minimum of $50 and a maximum of $5,000 per calendar year).
It is also good to know that earnings are exempt from state and local taxes, but they are taxed at the federal level unless they are used to pay for educational expenses.
These Bonds are also non-marketable, which means they can’t be sold in secondary markets. An individual can hold Series I Bonds for as little as one year or as long as 30 years. But, if they are sold after less than five years of ownership, the owner forfeits 3 months’ worth of interest as a penalty. As with any investment, be sure you understand the requirements, benefits, and drawbacks prior to investing.