A recent jump in the Consumer Price Index has brought more attention to inflation. And with it, the Social Security Administration recently announced a 5.9% increase to Social Security benefits to help offset more expensive prices.
Inflation directly impacts the cost of goods and services and, consequently, your cost-of-living. That’s why it’s important to make sure your financial plan accounts for inflation and its effects on your lifelong goals, including saving for retirement and education.
Here’s what you need to know about inflation — what it is, what causes it, how it’s measured — and how it may affect your personal finances.
What is inflation?
When most people think of inflation, they think of the rising prices of goods and services. So, something you buy today — say, a gallon of milk — will likely cost more when you buy it five or ten years from now. That’s inflation.
Another way of thinking about inflation is from the perspective of purchasing power. When talking about it in this way, inflation is what happens when a dollar buys fewer overall goods and services over time.
The main takeaway is that, because of inflation, a dollar doesn’t go as far as it used to.
What causes inflation?
There are a few factors that impact inflation. Primarily, inflation happens when the government increases the amount of newly printed currency as a way to address economic challenges or when there are sudden imbalances in supply and demand.
Specifically, when there is a surge in demand that outweighs supply or significant supply-chain issues creating shortages, inflation tends to go up more quickly.
Most recently, the COVID-19 pandemic has contributed significantly to rising inflation. Throughout the pandemic, we’ve seen a variety of factors that created a perfect storm for higher-than-usual inflation rates. In addition to supply-chain issues and staffing shortages, the government has pumped a lot of new money into the economy through stimulus checks and forgivable business loans.
Is inflation good or bad?
Both. Depending on the specific situation and environment, inflation can sometimes be a good thing and can sometimes be a bad thing.
Higher inflation is usually associated with economic growth or the expansion phase of a business cycle. Generally, this is a good thing for the economy.
On the other hand, if that economic growth or expansion isn’t felt equitably by everyday consumers, there are negative impacts. In these cases, goods and services become disproportionately more expensive and less affordable because consumers’ household income didn’t experience the same level of growth as the economy overall.
When this happens, inflation adversely affects their ability to maintain their standard of living.
How is inflation measured?
A lot of people measure inflation based on their own experiences. For example, if they notice their grocery bill has gone up, but their paycheck hasn’t. While unscientific, this is a fair and reasonable way to gauge inflation.
Officially, inflation is measured by a variety of price indices. Each index measures different “baskets” of goods and services.
As you can imagine, consumers’ interests are often different from businesses’ interests. For example, as a consumer, you may be much more interested in the price of food, utilities, and gasoline.
On the other hand, businesses are likely to be more concerned about the price of inputs used in production and manufacturing related to the products they sell.
One widely known index is the Consumer Price Index, or CPI. As defined by the U.S. government, the CPI is “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”
Analysts also measure and publish average price data for electricity, gasoline, and food.
These reports and indices help provide historical context and analyses. With this information, we are better able to pinpoint dips, spikes, trends, and anomalies with inflation and its long-term impacts.
How does inflation affect your personal finances in the short-term?
Have you ever had your parents or grandparents talk about the cost of bread back in their day? That’s inflation, and in some way, it impacts everyone.
According to the Bureau of Labor Statistics, the price of a basket of goods and services increased 5.3% over the past year. That’s the largest annualized increase since 2008.
The 5.3% increase in cost means that the average consumer has lost purchasing power. This represents an incremental and relatively insignificant change in the short-run, but growing inflation poses more serious financial risks over the long haul. As it increases over the course of many years, the value of the dollar in your pocket slowly — but continuously — diminishes.
Without looking at historical price shifts and inflation over many decades, it’s difficult to grasp the total impact of inflation.
For example, in 1950:
- The average home sold for just $7,354
- A brand-new Volkswagen Beetle sold for $1,280
- Tuition at the University of Pennsylvania was $600
- A cup of coffee cost a nickel
- A gallon of gas went for $0.27
During those times, lunch at McDonald’s would cost $0.15 — or $0.25 if you added fries and a drink. The average movie ticket cost $0.40, and tickets to a Major League Baseball game sold for around $1.
Times have surely changed. And looking at those prices compared to today’s, one might estimate a pretty high inflation rate over the past seven decades.
But in reality, the average inflation rate since 1950 is actually quite low at 3.46% per year.
Of course, that’s an average as measured by the CPI. Annual or even monthly inflation impacts some consumers differently than others. It also disproportionately affects the price of certain goods compared to others.
For example, the cost of housing prices, oil, and lumber has all increased significantly relative to other goods and services. And because of that, these products have also helped to further inflate the overall inflation rate.
So, if you weren’t in the market for a new home and owned an electric car, then inflation probably has not had as much of an impact on you over the past year as it has for a family purchasing their first home or a person with a long commute driving a gas-powered vehicle.
As with most things, there are two sides to the story when it comes to inflation. In addition to people who are negatively impacted by inflation, there are some people who benefit. For example, soaring property values mean that homeowners can get a lot more money for their home today than they could 12–18 months ago. So, although rising housing costs have negatively impacted renters and new homebuyers, they have greatly benefited landlords and home-sellers.
That said, homeowners almost always benefit from inflation over the long-term. That is why buying a home is considered a meaningful investment — and, although you may not realize it, an inflation hedge — because, more times than not, the value of real estate increases as time goes on.
Ultimately, when looking at a shorter period of time, inflation isn’t likely to have a significant impact on most consumers. In general, the impact of inflation is realized on a greater scale over long periods of time. Whether or not you’re helped or harmed is largely dependent on which goods and services increase in cost — and whether you’re buying or selling those higher-priced items.
How does inflation impact your long-term financial plan?
For most people, it’s unusual to feel any meaningful impacts from inflation on a month-to-month or even year-to-year basis. But without a thoughtful financial plan, they will feel the effects of inflation over several years and certainly over the course of their lives. That’s why it’s important to understand inflation and how to protect the value of your hard-earned money.
Inflation and saving for retirement
The impact of long-term inflation is an important risk for everyone, especially retirees. Assuming a 3-4% inflation rate, retired couples will lose 50% of their purchasing power over the next 25 years. In other words, if they chose to keep all of their money in cash (vs. investments), it would buy half as much 25 years from now as it would today.
This is why it’s important to consider inflation when building and implementing financial plans. Minimizing cash accounts over the long-term and wisely investing will help defend against inflation and maintain or improve purchasing power.
Effective wealth managers and financial advisors will account for inflation in their analyses, like retirement projections. At Elwood & Goetz, we are grateful and proud that none of our clients have ever had to reduce their retirement spending because of inflation (or even after a downturn in the market).
That’s an indication that our planning and recommendations more than accounted for inflation. We actually spend more time advising our clients on how they can spend more money to enjoy their retirement vs. spending less and reducing their standard of living because of inflation.
Inflation and saving for college education
Saving for college is different from saving for retirement, and that requires you to look at inflation a bit differently. The cost of college education has increased much faster than the overall inflation rate over the past few decades.
Although the future cost of college tuition is unknown, it’s safe to say that it will be significantly higher 10-20 years from now than it is today. Because of this, we typically advise using a much higher inflation rate when planning for college education. This allows families and parents to more effectively plan for college with minimal disruption to their lifelong financial goals and quality of life.
The CollegeBoard’s annual Trends in College Pricing report provides a lot of data that both consumers and financial advisors can use to assess and plan for college inflation rates.
Inflation and the stock market
Our clients often ask, “Will inflation adversely affect my investment portfolio?” While the answer will vary based on each person’s specific investments, we know that in general higher inflation doesn’t necessarily mean the market will drop or investments will decrease in value.
Over the past 30 years, one-year equity returns in the U.S. have varied tremendously. 23 of those yielded positive, inflation-adjusted returns. Meaning, the rate of return was higher than the annualized rate of inflation 23 out of the past 30 years. That’s a pretty solid track record and makes a strong case for long-term investing.
Examining the past three decades, there isn’t a reliable correlation between rising inflation and market returns. If anything, it’s often the case that rising inflation coincides with higher stock market performance. With this in mind, there’s no evidence that suggests higher inflation will negatively impact the stock market or a person’s investment portfolio over the long term.
We proactively account for inflation in our clients’ financial plans by holding certain asset classes that tend to keep pace with or outperform inflation. Through a combination of other effective financial planning strategies, we put our clients in a position to free up more of their income so they can strategically invest in assets that act as inflation-hedging shields.
Over time, inflation will impact everyone in some way. The degree to which it impacts you is likely different than how it will affect someone else. Those differences are primarily based on which goods and services experience the highest inflation rates and whether you’re the one buying or selling at the higher (inflated) price.
On the whole, inflation will almost certainly continue slowly but steadily throughout time. Short-term spikes are likely to occur when there are supply-chain disruptions that create supply shortages or when there’s additional money poured into circulation to stimulate the economy.
For the most part, you won’t feel the effects of inflation over very short periods of time. That said, there are remarkable exceptions, like the COVID-19 pandemic, where inflation will disproportionately and sometimes suddenly impact the price of certain products. These are difficult to predict and fully plan for, but the possibility reinforces the importance of a strategic and thoughtful financial plan.
It’s a common and understandable concern that rising prices will make it more difficult to meet long-term financial goals. But the truth is, the stock market has historically and consistently outpaced inflation over the long-term.
Ultimately, a well-managed, monitored, and optimized financial plan and investment portfolio will largely insulate you from inflation. Working with an experienced financial advisor to implement evidence-based strategies and make wise investments can help you ensure the money you’re earning and saving today doesn’t lose its value before you need it.