You will undoubtedly have read about inflation in one way or another over the last couple of years. Rising inflation and its effects on savings are topics of much discussion and worry.
Inflation occurs when our money doesn't purchase as much as it used to as prices rise and inflation increases. In this article, we will examine how inflation affects investments and savings, and we'll provide you with strategies for preparing for rising inflation.
What is inflation?
The primary definition of inflation is the general rise in prices over time. Typically, a percentage is used to indicate it. Imagine that during the course of a year, the average cost of a used car rose from $10,000 to $10,500.
There would be 5% inflation. Inflation can be measured for particular products or services, like the vehicle example above, or a more general category, like energy costs. The most widely used metric in the US is the consumer price index (CPI).
The market basket, which is a collection of different commodities and services, is what is measured by the CPI. For the CPI, the Bureau of Labour Statistics gathers actual price information from live consumers.
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What causes inflation?
Inflation, which is an increase in the price of goods and services, can occur for a variety of causes. Any factor that might have an impact on consumer goods pricing has the potential to cause inflation.
Inflation is essentially due to two basic factors, though:
- Consumer-driven inflation
- Price-driven inflation
Built-in inflation, the third type of inflation, can develop as a result of the first two.
Basic supply and demand is demand-pull inflation. It occurs when customer demand for goods or services exceeds manufacturers' capacity to meet it.
As a result, there is a finite supply of goods or services. As a result, customers are inclined to pay more for it. The cost then goes up. As long as supply is limited and demand is great, the price will rise.
Inflation is most often caused by demand-pull. Any time there is extra money available for customers to spend, it can happen. Demand-pull inflation can result from rising salaries in a booming economy. As workers' wages rise, they begin to spend more, which causes the supply to decline overall.
Example of demand-pull inflation
Using the example of a single workplace, we may examine this on a smaller scale. Consider that there is an on-site cafeteria where hamburgers are $5. Most workers prefer to preserve their money rather than spend it on a hamburger. The company chooses to increase everyone's wages, nevertheless.
The workers decide to treat themselves to lunch now that they have extra money. Due to high demand, the cafeteria raises the price to $8.
Demand-pull inflation results from more people demanding a product that is in short supply. On the other side, cost-push inflation results from rising production costs.
A product's price rises in direct proportion to its production costs. The product's additional manufacturing costs must be accounted for by retailers and manufacturers when determining the final price.
Example of cost-push inflation
Crude oil prices are by far the most typical illustration of cost-push inflation. Every industry that depends on oil has to spend more to produce its goods as the price of oil rises.
These costs are transferred from manufacturers to retailers, who then pass them on to customers. Cost-push inflation is something you've probably noticed at the petrol station; as crude oil prices rise, so do petrol costs.
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When workers demand greater wages as a result of rising product costs, this is referred to as built-in inflation. Either cost-push inflation or demand-pull inflation directly causes it.
As the cost of consumer items rises, workers want higher pay to match living expenses. This may set off a cycle of rising prices and wages for commodities.
However, inherent inflation depends on employees' beliefs that prices would rise further. If the cause of inflation is dealt with, prices should remain constant. Built-in inflation typically declines when prices start to level out.
Let's first discuss how inflation affects the value of money before going deeper into how inflation affects your savings.
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How does inflation impact the value of money?
Well, rising prices result in inflation. Your money's actual value is not diminished. Your $1 bill won't become a $0.50 bill due to rising inflation. But it can push up the price of a household product from $1 to $2.
Due to decreasing purchasing power, higher prices indicate that one dollar won't purchase as much as it did before inflation.
How does declining purchasing power work?
The number of things or services you can buy with a specific quantity of money, such as dollars, is known as your purchasing power. A rise in inflation results in less spending
Your dollar doesn't purchase as much as it used to as prices for items rise. In the previous year, an automobile cost $10,000. This year's cost has increased to $11,000 due to rising inflation. You now have less money to spend since you need an extra $1,000 to buy the car.
What impact does inflation have on households?
The price of basic goods and services has increased over the last couple of years. The Consumer Price Index shows that costs rose across the board:
- Cereals and pastry goods saw a 6.8% increase.
- Fish, eggs, poultry, and meats all saw 12.2% growth.
- Vegetables and fruits increased by 5.6%.
- Costs of electricity rose by 10.7%.
- Clothing grew by 5.3%
- Prices for used automobiles and trucks jumped by 40.5%.
Your household budget will definitely be strained as costs rise. You won't have as much money left over after paying for necessities like food and petrol. This can make it more difficult to save money or pay off debt.
Here's an illustration of how inflation affects a household;
Susan makes $3,000 every month. Her monthly mortgage and insurance payments total $2,000.
Her monthly minimum payment for her debts is $300. Typically, she spends $500 on food, gas, and other items like clothing. She now has $200 to use for savings, investments, and further debt repayment.
Food prices and other prices rise as a result of inflation. Susan now has to pay for these consumer items on a monthly basis of about $650.
Only $50 is left for her to save or apply to her debt.
How does inflation impact your savings?
Savings are most significantly impacted by inflation. You can often receive interest on your balance in savings accounts. Your savings interest rate needs to increase to keep up with inflation when it occurs.
The impact of inflation on savings is caused by a decrease in purchasing power if your savings rate lags behind the current rate of inflation.
Here is an illustration of how inflation affects savings accounts;
You have a savings account where you receive 1% yearly interest.
There is $1,000 in your account.
You'll make $10 in interest over a year.
Inflation must remain at or below 1% in order to maintain the purchasing power of your interest profits. Your money loses purchasing power if inflation is higher.
How does inflation impact investments?
The majority of investments outperform cash when inflation is rising.
The performance of an investment amid inflation can, however, be affected by a wide range of diverse circumstances.
Stocks are erratic investments. During inflation, this becomes even more obvious. This is because inflation may lead certain equities' values to soar while driving down others.
Why are stocks erratic when inflation is high?
The way a business reacts to inflation may alter its valuation. Let's imagine Company A increases the price of its goods by 10% while maintaining the same level of demand.
They are able to maintain relatively flat labor and production costs compared to prior inflation. As profits exceed expenses, their stock will probably increase.
Contrarily, Company B increased prices by 10% while simultaneously seeing a 15% increase in production expenses. The share price of the corporation may decline as its profits and worth decline.
Investments in real estate frequently do well during inflation. Property values typically rise in tandem with inflation. As a result, your property may be worth more now than when you purchased it or made an investment in it.
For instance, suppose you paid $200,000 for a house and still owe $100,000 on the mortgage. Since prices have increased owing to inflation. Your residence is currently valued at $250,000.
You only owe $100,000, though. Your equity now stands at $150,000 as opposed to $100,000.
Commodities Typically, commodity prices rise in tandem with inflation. Even commodity prices can serve as a gauge for inflation. Commodity raw resources like metals and crude oil are used to manufacture the majority of products.
The cost of the products made from commodities will probably increase if their prices do.
Fixed-income investments typically perform worse amid inflation than other types of investments do. Assets like corporate bonds or certificates of deposit (CDs) are examples of investments with fixed income.
You get a guaranteed rate of return on your money from these goods. Fixed-income investments are a wonderful way to earn assured returns during periods of low inflation. The fixed interest rate might not, however, be sufficient to beat inflation. Your interest rate stays the same as inflation rises.
In times of inflation, fixed-income investments function very similarly to savings accounts.
TIPS, or Treasury Inflation-Protected Securities
Fortunately, some fixed-income investments offer some level of inflation protection. Government bonds that are inflation-adjusted are known as Treasury Inflation-Protected Securities (TIPS). The Treasury modifies the principle, or initial amount, of your bond when inflation rises.
Take the $1,000 TIPS bond with a 2% return as an illustration. You are paid $20 in interest. The following year, inflation goes up by 5%. The Treasury reduces your investment to $1,050 in order to preserve your purchasing power.
The returns are still 2%, but because the principal is greater, your profit is $21 rather than $20.
How to prepare for the effects of inflation on assets and savings
Savings that are affected by inflation may result in decreased purchasing power. But it plays a significant role in the economy. Your assets and purchasing power can be protected if you prepare for rising inflation.
See what measures you can take to protect your finances as inflation starts to rise;
1. Add variety to your investment holdings
One of the best methods to hedge against inflation is to use a variety of investments. A portfolio with a variety of holdings might contain some stocks, bonds, and tangible assets like commodities.
However, keep in mind that diversifying your portfolio doesn't ensure a profit. Any investment has the potential to fluctuate and lose value.
2. Select stocks that are resistant to inflation
When selecting stocks for your portfolio, make sure to do a thorough research. You may, for instance, look at historical pricing from earlier inflationary eras.
Does the company's worth consistently rise during periods of high inflation?
Or does the value of the stock decline as inflation increases?
This might assist you in deciding whether a stock could be a good addition to your portfolio.
3. Keep emergency money on hand
When inflation is on the rise, should you take your money out of your savings account? No, it's crucial to retain some accessible cash on hand in case of an emergency.
Although the impact of inflation on savings can result in this money-losing purchasing value, it nevertheless allows you to pay for unexpected costs.
If you invest all of your money, you won't be able to access it until you sell the investments. It can take several working days, which makes it challenging to cover an unexpected expense. Aim to maintain cash savings for three to six months' worth of spending.
4. Spend wisely
A salary raise is usually provided to employees by many firms. When inflation is manageable, this yearly rise aids in reducing it. Increases in the cost of living may not be sufficient to offset actual cost increases when inflation is higher than usual.
Thus, even though you earn more money, your purchasing power decreases. By comparing your present salaries to your cost of living, you can make sure that they are keeping up with inflation.
Essentially savings and investments may lose value over time due to inflation because future prices and cost of goods will increase.
If you keep $10,000 beneath your mattress tonight, it might not be worth as much 20 years from now.
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