What is inflation? Here's why the cost of goods rises and what it means for your investments and savings
Inflationis the increase in the prices of goods and services in an economyover time.
- While a low, steady inflation rate around 2% annually is desirable, indicating a healthy economy, high or rapidly changing inflation is dangerous.
- Inflation lowers the value of cash savings. To hedge against it, invest in stocks, TIPS, or tangible assets like real estate.
Does it feel like a dollar buys less than it used to? You're not imagining things. "It's inflation," people sigh.
You probably have a rough idea of what inflation means. The cost of things is going up.But what is inflation really, what causes it, and how does it affect your finances? Here's everything you need to know about this everyday economic term.
What is inflation?Inflation is an increase in the prices of goods and services in an economy over a period of time.
That means you lose buying power - the same dollar (or whatever currency you use) buys less. That means it's worth less.Remember that modern money really has no intrinsic value - it's just paper and ink, or, increasingly, digits on a computer screen. Its value is measured in what or how much it can buy.
Quick example: If apples cost 25 cents apiece, one dollar buys four of them. But say apples become scarcer or more expensive to grow, and the next year, the grocer prices them at 50 cents apiece. Now one dollar buys only two of them. In purchasing-power terms, the dollar has effectively lost half its value (at least as far as apples are concerned).
Inflation is measured by the "inflation rate," which is the percentage of change from year to year of a price index - usually, in the US, the consumer price index (CPI). The CPI is a basket of goods and services that most people buy. Increases in the cost of that basket indicate inflation.Why use a basket of goods? Because the prices for different things change differently. For example, tuition and healthcare costs increase quite quickly, while food costs increase more slowly and the cost of electronics often decreases. Using a basket tells us about changes in prices in general.
Real versus nominal prices
To make meaningful historical cost comparisons - to compare apples to apples, so to speak - economists adjust prices for inflation.
When you hear a price from the past talked about in "real" dollars, that means the price has been adjusted for inflation. When you hear prices from the past talked about in "nominal" dollars, that means it hasn't been adjusted.
What causes inflation?There's a massive economic literature on the causes of inflation and it's fairly complex. Basically, though, it comes down to
Keynesian economists emphasize that it's demand pressures that are most responsible for inflation in the short term.
- Demand-pull inflation happens when prices rise from an increase in demand throughout an economy.
- Cost-push inflation happens when prices rise because of higher production costs or a drop in supply (such as from a natural disaster).
Other analysts cite another cause of inflation: an increase in the money supply - how much cash, or readily available money, there is in circulation. Whenever there's a plentiful amount of something, that thing tends to be less valuable - cheaper. Indeed, many economists of the monetary school believe this is one of the most important factors in long-term inflation: Too much money sloshing around the supply devalues the currency, and it costs more to buy things.
Is inflation good or bad?Inflation is certainly a problem when it comes to ready cash that isn't invested or earning anything. Over time, it'll erode the value of your cash and bank account. It's also the enemy of anything that pays a fixed rate of interest or return.
In general, economists like inflation to occur - at a low, steady rate. It indicates a healthy economy: that goods and services are being produced at a growing rate, and that consumers are buying them in increasing amounts, too. In the US, the Federal Reserve targets an average 2% inflation rate over time.When inflation starts mounting higher than that or changes quickly, it can become a real problem. It's a problem because it interferes with how the economy works as currency loses its value quickly and the cost of goods skyrockets. Wages can't keep up, so people stop buying. Production then stops or slows, and an economy can tumble into recession.
Types of extreme inflation
Hyperinflation refers to a period of extremely high inflation rates, sometimes as much as price rises over 50% per month for several months. Hyperinflation is usually caused by government deficits and the over-printing of money. For example, hyperinflation occurred during the US Civil War when both the Union and the Confederate states printed money to finance their war efforts.In a modern case, Venezuela is experiencing hyperinflation, reaching an inflation rate over 800,000% in October 2020. Stagflation is a rare event in which rising costs and prices are happening at the same time as a stagnant economy - one suffering from high unemployment and weak production. The US experienced stagflation in 1973-4, the result of a rapid increase in oil prices in the midst of low GDP.
How inflation is controlled
Governments can control inflation through their monetary policy. They have three primary levers.
- Interest rates. Increasing interest rates makes it more expensive to borrow money. So people spend less, reducing demand. As demand drops, so do prices.
- Bank reserve requirements. Increasing reserve requirements means banks must hold more money in reserve. That gives them less to lend, reducing spending and leading (hopefully) to deflation, a drop in prices.
- Supply of money. Reducing the money supply reduces inflation. There are several ways governments do this; one example is increasing interest paid on bonds, so more people buy them, giving more money to the government and taking it out of circulation.
How should you invest for inflation?
Investing for inflation means ensuring that your rate of return outpaces the inflation rate. Certain types of assets may beat inflation better than others.
- Stocks. There are no guarantees with the stock market, but overall and over time, share prices appreciate at a rate that typically exceeds the inflation rate. Most index funds also post returns better than inflation.
- Inflation-indexed bonds. Most US Treasuries pay the same fixed amount of interest - whose value erodes if inflation is rampant. However, with one type of bond, called Treasury Inflation-Protected Security (TIPS), interest payments rise with inflation (and fall with deflation).
- Physical assets and commodities. Alternative investments - often, tangible assets like gold, commodities, fine art, or collectibles - do well in inflationary environments. So does real property: Zach Ashburn, president of Reach Strategic Wealth, notes, "returns on investments in real estate have kept up with, or surpassed, rates of inflation for many periods in the past." That's because these physical assets, unlike paper ones, have intrinsic value, and are sold and priced in markets outside the conventional financial ones.
The financial takeaway
Inflation means costs and prices are rising. When they do, it means that paper money buys less. Low, steady inflation is good for the economy but bad for your savings. Ashburn says, "While having cash available is important for financial security, cash will see its value slowly eaten away by inflation over time."
To beat inflation, don't leave your cash under your mattress - or in any place where it's stagnant. It has to keep earning.Instead, aim to structure your portfolio so that it provides a rate of return - one that's hopefully better than, or at least keeps pace with, that of inflation, which is almost always happening. If you do, it means that your investment gains really are making you richer - in real terms.
Related Coverage in Investing:
Beginner's guide to investing in gold: The major ways to buy and trade gold, and the benefits and drawbacks of each
What are commodities? Tangible, everyday goods you can invest in, to hedge against inflation or sinking stock prices
Investment income is money earned by your financial assets or accounts, and understanding how it works can help maximize your profits
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