Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Inflation, according to the Bureau of Labor Statistics, is the upward price movement of goods and services. In more relatable terms, inflation is what happens when things like health insurance, houses and food gets more expensive over time.
When inflation goes up, the buying power of one dollar goes down. Currently, the inflation rate is 1.7%. That number might seem small, but there's a lot of power behind it. Inflation has plenty of influence on your savings, investments, loans and more.
What is inflation?
Inflation is the steady increase in the price of products in an economy. It refers to the collective goods and services, not one specific item. For example, if the newest diet craze involves eating a head of cabbage for every meal, and Americans suddenly go nuts for cabbage resulting in a price increase, that's not inflation — inflation is when the price of everything goes up, not just cabbage.
Inflation is driven by two main factors: the demand-pull effect and cost-push effect. Here's a breakdown:
- Demand-pull effect: This happens when consumer demand depletes supply. When the demand for a product outpaces the supply, prices go up.
- Cost-push effect: This happens when there's an increase in the cost of raw goods, materials or wages. Companies adjust to this by passing the increased cost of production onto consumers in the form of higher prices.
Inflation matters because it affects your purchasing power. When inflation rises, the value of your dollar sinks.
“Inflation doesn’t impact money directly, it impacts prices,” explained Lending Tree Chief Economist Tendayi Kapfidze. “Inflation reduces the purchasing power of your money because it is a measure of how prices change. As prices rise, a fixed amount of money — say, a dollar — will buy smaller quantities of goods or services in the economy.”
How is inflation measured?
The U.S. government measures inflation via these two key indices:
- The Consumer Price Index (CPI)
- The Producer Price Index (PPI)
The CPI is a measure of what common items (food, transportation and health care, for example) cost at various locations across the nation. For example, to formulate the CPI, the government considers what a gallon of milk and a gallon of gas cost in Nebraska compared to what they cost in Ohio.
The PPI is a measure of the average selling prices received by companies for their products. The PPI differs from the CPI in that it is viewed through the lens of producers, while the CPI is viewed through the lens of consumers.
Once data on prices is collected from all over the country, the government and the Federal Reserve analyze CPI and PPI trends to help make policy and guide decisions. The Fed considers the numbers over long periods of time to avoid jumping the gun on erratic spikes in prices (like that odd cabbage fad). When analyzing inflation trends, the Fed can also cut out items that have a tendency to have price volatility, like a gallon of gas.
How does the government manage inflation?
There are three strategies to manage inflation. The Federal Reserve manages the first strategy: tightening monetary policy. When the Fed increases interest rates, this reduces the money supply. The reason for that is if interest rates rise, rates for things like savings accounts and CDs go up with it. This change makes consumers more likely to hold onto their cash so they can take advantage of higher rates. Also, when it's more expensive to take on debt, businesses hesitate to do so. All of this reduces spending. When spending is cut back, the economy cools off and rates of inflation decline.
The Fed is also in charge of strategy number two: compelling banks to boost their reserves. This cash stash is technically referred to as reserve requirements. Essentially, the Fed sets specific thresholds that tell banks how much money they need to keep on hand and not lend out in order to cover consumer withdrawals. If the Fed increases reserve requirements, banks have less money to lend to consumers, which lowers spending and cools off inflation.
The third method for managing inflation is reducing the money supply through government spending policies. One way of doing this is to make bonds more attractive to investors by increasing the interest rates. The government can also seek to have its debts paid. Both of these strategies end up controlling inflation by increasing the amount of money flowing into the government, where it can better control how it flows back out to consumers.
The effects of inflation on your money
Inflation impacts the economy as a whole, which means you feel its effects all the time. When inflation happens, you'll see it reflected in your savings, investments and loans.
Inflation impact on your savings
Inflation impacts your savings because it essentially reduces your buying power. When the rate of inflation is higher than the savings rate offered by your bank or credit union, you're losing money. If you have $100 stashed in a savings account with a 1% APY, but the inflation rate is 2%, you're in trouble. That means after one year you'd have $101 saved, but you'd actually need $102 to maintain buying power.
Inflation impact on your investments
The impact of inflation varies depending on the kind of investments you hold. If you have a CD with a fixed interest rate, inflation will pummel it, as your returns become worth less every year due to inflation. If you have stocks, though, inflation is a mixed bag. It's good in that when inflation is high, companies are likely to sell more, which boosts your share prices. However, inflation is bad for stocks because it results in companies having to pay more for raw goods and workers.
Inflation impact on your loans
Just like investments, inflation's impact on loans depends on the type. If you have a long-term, fixed mortgage, a high inflation rate is good for you. That's because you'll essentially be paying back the loan using lower-valued dollars.
Meanwhile, if you have a variable rate loan or a credit card with a variable rate, inflation is bad in that your interest rates will also likely go up. That means increased borrowing costs and monthly payments.
As you can see, inflation isn't entirely a negative; “not unambiguously bad,” as Kapfidze explained.
“A small amount of inflation is welcome as it encourages people to spend, [because] a dollar will be able to purchase less in the future,.” he said. “It also encourages investment which helps the economy grow.”
How to protect your money from inflation
Shop around for the best interest rates
One way to combat inflation is to shop around for the best interest rate for your savings accounts. Use comparison tools from sites like DepositAccounts to find the best rates available. Kapfidze suggested paying close attention to online banks, as they usually offer higher interest rates than brick-and-mortar banks and credit unions because they have less fixed costs (like branches and ATMs). Keep in mind that even the best interest rate available can have trouble keeping pace when inflation is high.
Invest in the stock market
Another way to combat inflation is to own stock. You will need to consider all the associated aspects first. Understand that while stocks can earn more than the inflation rate, they can also produce a loss. Before investing, consider your risk tolerance level. Are you okay with short-term losses in order to experience a long-term gain? Investing is a big picture game — you have to be able to see the forest, not just the trees.
If you're more of a conservative financial person, you might want to consider inflation-indexed investments, like Series I Bonds. These investments are guaranteed to offer a return higher than the rate of inflation as long as you keep it for its full-term. Meanwhile, if you invest in stocks that offer a higher rate of return, you could potentially benefit from that strategy over time.
Investing can be complicated, so if you need help, seek it out. The most important thing to do is to start investing right away.
“Investing is the best way to protect against inflation,” added Kapfidze. “Since there are so many different ways to invest, it's often a good idea to speak with a financial advisor.”
The bottom line
Inflation is neither completely good or completely bad. It is, however, unavoidable. The best way to deal with inflation is to understand it and combat it through strong savings accounts and smart investments.