After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn't intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.
Some points to remember:
- Inflation is a sustained increase in the general level of prices for goods and services.
- When inflation goes up, there is a decline in the value, or purchasing power of money.
- Variations on inflation include disinflation, deflation, hyperinflation and stagflation.
- Theories as to the cause of inflation are up for debate. Some common theories include demand-pull inflation, cost-push inflation, and monetary inflation.
- When there is unanticipated inflation, creditors lose, people on a fixed-income lose, menu costs go up, uncertainty reduces spending and exporters aren't as competitive.
- Lack of inflation (or deflation) is not necessarily a good thing and can lead to destabilizing deflationary spirals.
- Inflation is measured with a price index.
- The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes. The GDP- and Price-deflator are also used.
- Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed's decisions regarding interest rates since it uses inflation-targeting as a policy.
- In the long term, stocks and precious metals are good protection against inflation.
- Inflation is a serious problem for fixed income investors. It's important to understand the difference between nominal interest rates and real interest rates.
- Inflation-indexed securities offer protection against inflation but offer low returns.
How Does Inflation Impact My Life? Impact on You and the Economy
Why President Reagan Said "It's as Violent as a Mugger"
Inflation hurts your buying power. It means you have to pay more for the same goods and services. Inflation can help you if you are a lucky recipient of income inflation. You also might benefit from asset inflation, such as in housing or stocks, if you own an asset before the price rises.
But if your income doesn’t increase or increases at a slower rate than general inflation, your buying power declines.
Many people get hurt by an asset bubble if they try to time it. Most people buy right when the bubble is about to burst. Overall, inflation reduces your standard of living.
Inflation doesn't affect everything the same way. Gas prices can double while your home loses value. That's what happened during the financial crisis of 2008. There was deflation in home prices, which fell 31.8 percent.
Meanwhile, inflation occurred in oil prices. They reached an all-time high of $148 a barrel. Since oil prices drive gas prices, the cost of gas rose to $5 a gallon. Driving to work became even more expensive and stressful. That was at a time when many workers were worried about keeping their job. For more, see Inflation and Deflation: Causes and Effects.
The federal government enacted the economic stimulus plan to end the recession. Then the Federal Reserve started quantitative easing. Investors grew worried about inflation.
As a result, they bought gold. The price of gold rose to a record of $1,895 an ounce on September 5, 2011. In this instance, there was inflation in gold and oil prices with deflation in housing prices and personal income.
Inflation has another side effect. Once people start to expect inflation, they will spend now rather than later.
That's because they know prices will be higher later. Consumer spending heats up the economy, creating ever-higher inflation. It's called spiraling inflation because it spirals out of control.
If inflation reaches the double-digits, that's hyperinflation. If it happens, you will need a wheelbarrow of money to buy a loaf of bread. Hyperinflation only happens when the government is so irresponsible that it prints money without regard to the inflation rate. It happened in Germany in the 1920s and in Zimbabwe in the 2000s. If inflation ever approaches the double-digits, your best defense is to buy gold or any currency that isn't pegged to the dollar. For more, see U.S. Economic Collapse.
Effect of Inflation on Retirement Planning
The combination of inflation in some asset classes and deflation in others, makes financial planning more difficult. Rules of thumb no longer apply. One of the reasons government economists didn't do more to head off the recession was because they couldn't believe housing prices would ever fall.
Inflation is really bad for your retirement planning. Your target must keep rising to pay for the same quality of life. In other words, your savings will buy less as time goes on.
As a result, to be prepared for inflation during your retirement, you should save more than you think you will need.
Impact of Inflation on Treasury Bonds
Inflation is important if you hold bonds or Treasury notes. These fixed income assets pay the same amount each year. As inflation rises faster than the return on these assets, they become less valuable. People rush to sell them, further depreciating their value. When that happens, the U.S. government is forced to offer higher Treasury yields to sell them at all. This increases most mortgage interest rates.
This lowers the value of your investments. It also increases the cost to the federal government of financing the U.S. debt. It increases the interest on the national debt. The additional budget expense needs to be offset by a cut in the discretionary budget or an increase in taxes.
Otherwise further deficit spending will occur. All of those are contractionary fiscal policies that slow economic growth. That translates into a lower standard of living for you.