Remember the price of a movie ticket 15 years ago? That ticket costs much more today, thanks, in part, to the effect of inflation. This economics term refers to the tendency of prices (for consumer goods, services, housing) to gradually rise over time. Inflation also has the tendency to cut down on the value of your savings. That’s why it’s important to understand inflation and manage its effects.
How does inflation affect savings?
Let’s say you have $100 in a savings account that pays a 1% interest rate. After a year, you will have $101 in your account. During this period, if inflation runs 2%, you would have to have $102 to make up for the impact of higher prices. Since you will only have $101 in your account, you have actually lost some purchasing power. If your savings don’t grow to reflect this rise in prices over time, the effect will be as though you are actually losing money.
If you are a retiree living on your limited savings, you can’t keep up your standard of living if inflation cuts into your purchasing power with every passing year. In the United States, medical costs, an essential expense for most retirees, have a tendency to rise. Inflation also affects those who aren’t living on a fixed income. What if you are steadily saving money with a goal in mind, such as a college fund for your children or a down payment for a home purchase? You don’t want to see your actual purchasing power decline as prices go up every year, diminishing the monetary amount of the college tuition or house you can afford to buy.
What’s behind inflation?
Inflation comes about as demand for goods and services grows in an economy. As the money supply in an economy rises, there is likely to be more demand from consumers looking to buy various goods. This rising demand creates a pressure on prices and they rise. As more people are willing to pay for these goods, sellers hike up their prices. Another situation that could lead to inflation is when the there is an increase in the costs of production. The producers then pass on the costs, in the form of higher prices, to consumers.
Measuring inflation
Now you may be concerned about whether you are actually losing money on your savings. So how do you measure the effect of inflation? There are certain indices that the government puts together to measure the effect of rising prices. The Consumer Price Index, for one, includes the prices of a variety of goods and services that consumers buy. This includes the prices of transportation, medical care and housing, among others. A rising CPI indicates that the costs of such consumer items are increasing. Tracking this index, published monthly by the Department of Labor, gives you an idea of the level of inflation in the U.S.
Inflation in the United States
In recent years, inflation has been running so low that central banks in the U.S., Japan and Europe have been actively trying to stoke inflation and ward off the specter of deflation, or falling prices. In the U.S., for instance, the Federal Reserve is targeting a 2% annual growth in inflation. The bank initiated various stimulus measures to boost the economy following the financial crisis and great recession.
Back in 2008, there was some talk that the inflow of cash from the Federal Reserve’s stimulus measures would actually lead to a high rate of inflation in the U.S. That sort of situation hasn’t come to pass though, and the Federal Reserve is still trying to boost inflation in a tepid economy. Things weren’t always like this. Back in the late 1970s, the Fed was more geared toward fighting high double-digit rates of inflation. And there have been periods of hyperinflation, or very high inflation, in countries such as Germany.
Safeguard your savings from inflation
Even though there is scant evidence of inflation in the U.S. today, it is likely to be more of an issue at some point. The good news is that there are ways of managing the situation. If you are a retiree who gets a government social security payment, the government adjusts the payment based on the cost of living as measured by the Consumer Price Index. Thus, as inflation rises, you will also see your social security payment rise.
There are also ways you can ward off the impact of inflation on your personal savings. For one, instead of holding on to your cash savings, aim to invest them for a better return. The minimal returns that money market accounts and savings accounts tend to offer aren’t enough to account for inflation, so parking your money there is not likely to safeguard your purchasing power.
Instead, aim to be more aggressive with your money to get a better return. For retirees, instead of investing in plain government Treasuries, you might want to consider Treasury Inflation-Protected Securities, or TIPS. These securities adjust the interest payouts you get based on changes in the CPI. And the principal payment you get back will also be adjusted for inflation. In case prices have gone down over your investment period, you will at least get back your original principal.
And returns on stock investments generally tend to beat inflation. While investors focused on capital preservation may not be interested in the volatility associated with individual stocks, opting for mutual funds would likely provide a good return. Considering that such funds have exposure to a wide variety of stocks, you will not be putting all of your eggs in one basket. A mutual fund that follows a passive indexing approach might be even better since it is not dependent on the stock-picking abilities of any particular fund manager. The stock market tends to go up over time and you will benefit from this exposure. You will also pay less in fees with an indexing approach.
The Bottom Line
Inflation refers to the upward march of prices in an economy over a period of time. This tends to cut into a consumer’s purchasing power; she can only afford to buy a reduced amount of goods and services with the same money over a period of time. Fortunately, there are ways of managing for inflation so that you can preserve your purchasing power.
