Money Girl explains the root of inflation and what temporary (or long-term) price hikes mean for your finances. Learn tips and investment strategies to prevent inflation from eroding the value of your money now and in the future.
If you've been hearing a lot of experts talking about whether inflation will rear its ugly head, you might be wondering if you should do something different with your money.
Many economists believe that the recent higher-than-normal prices of goods and services will be temporary. When the economy is fully open, and manufacturing and shipping bottlenecks get cleared, we should see the inflation rate drop to pre-pandemic levels.
However, no matter if inflation in the U.S. is temporary or long-term, it's wise to consider what it means for your finances. This episode will review what causes inflation and tips to keep it from causing you to lose money now and in the future.
What is inflation?
First, here's a quick primer on inflation. It's a rise in the prices of goods and services over time. You've probably heard numbers like during the 1940s in the U.S. you could buy a loaf of bread for $0.15 and a new car for less than $1,000!
Here's a handy inflation calculator that allows you to adjust any amount for inflation from 1800 to the present.
The most well-known measure of inflation is the Consumer Price Index or CPI. The CPI reveals changes in retail prices of specific consumer goods such as food, clothing, and cars. The index compares the value of the same items each year to calculate the level of inflation for that period. It's published monthly by the Bureau of Labor Statistics.
As inflation causes prices to rise, every dollar buys a smaller percentage of a good or service. For example, if the inflation rate is 4%, then a $2 loaf of bread will cost $2.08 in a year. After inflation, our money doesn't buy the same amount of goods or services that it did before. That's why people fear inflation so much.
As of June 2021, the prices of certain products and services have gone up the most since 2009, which was about the last time I wrote about inflation!
Over the past year or so, the pandemic created some unusual economic conditions. And while the recovery is underway, it's not happening smoothly or equally across industries. For instance, car manufacturers are still behind, but restaurants and hotels are poised for a post-vaccine boom this summer.
The critical question is whether the current inflation rate hike will last or even increase? And how can you protect yourself from getting hurt financially by it?
What causes inflation?
Let's take a step back and talk about what causes inflation in the first place. One factor is increases in the money supply of an economy.
Consider an imaginary economy where nothing exists except loaves of bread and dollars printed by the government. When more money is printed and gets into the hands of consumers, there are more dollars available to buy the same amount of bread. That drives up prices that consumers are willing to pay for a limited supply of bread.
There are shortages in specific industries, such as computer chips and lumber, due to manufacturing and delivery delays. The pandemic kept people from working and products from being delivered. However, those supply chain clogs should eventually get removed.
Another cause of inflation is wages. When workers command higher salaries due to expertise, lack of competition, or bargaining power, employers generally pass the increased expense to their customers.
When workers command higher salaries due to expertise, lack of competition, or bargaining power, employers generally pass the increased expense to their customers.
In other words, prices of goods and services go up in a labor shortage. And right now, we are in a labor shortage, to boot. However, as more Americans return to work or move from part-time to full-time jobs, we should see fewer employers scrambling to restaff.
5 investments to beat inflation
If your savings earn less than the inflation rate, you're losing purchasing power day by day. And even when you earn higher rates, inflation still eats away at the value. For example, if your CD earns 3% and inflation is 2.5% per year, your real interest rate is 0.5% (3% - 2.5%).
So, how can you beat, or at least minimize, the effects of temporary or long-term inflation? Here are five investments designed to protect you from inflation:
1. Treasury Inflation-Protected Securities (TIPS)
TIPS are backed by the federal government and pay interest adjusted for inflation as measured by the CPI. If you own TIPS inside a tax-advantaged account, such as an IRA, SEP-IRA, or 401(k), you avoid or defer paying tax on your earnings.
2. Municipal Inflation-Linked Securities
These securities are issued by various government entities and pay interest based on the CPI. Municipal inflation-linked securities are similar to municipal bonds because they're exempt from federal and most state and local taxes.
3. Corporate Inflation-Linked Securities
These investments are sold by companies and carry more risk and potentially higher returns than government-issued investments. The yields adjust monthly for changes in the inflation rate.
4. Inflation-Linked Certificates of Deposit (CDs)
These securities are sold by banks and various financial institutions and pay an interest rate based on the inflation rate. They're insured by the Federal Deposit Insurance Corporation (FDIC), just like your bank checking and savings accounts.
5. Inflation-Linked Savings Bonds (I Bonds)
I bonds are backed by the federal government and grow with inflation-indexed earnings. They're exempt from state and local taxes, and you defer paying federal tax until the bonds mature or get sold.
What's the best inflation investment strategy?
More financial institutions are marketing inflation-protected securities and funds to investors who believe inflation will continue to rise. The advantage is a guarantee that you'll receive a return higher than inflation. However, the returns are relatively low compared to other options, such as stock funds.
As I mentioned, companies tend to pass along inflation to their customers as higher prices. That can help companies maintain profitability, boost their value, and have higher stock prices, allowing stock funds to rise.
Inflation is most problematic for those who are nearing or are in retirement.
Inflation is most problematic for those who are nearing or are in retirement. If you're on a fixed income from investments, a company pension, or Social Security retirement benefits, you may benefit from owning some inflation-protected investments.
However, if you have a long investment horizon or many years to go before you plan to retire and begin tapping your nest egg, you really shouldn't change your investing strategy. If you're regularly buying one or more diversified funds in a retirement account, such as a 401(k) or IRA, that's a rock-solid approach to keep.
Having a diversified portfolio means you own many investments that don't all move in tandem. When your investments perform differently in different inflationary environments, that allows you to earn more with less risk, which is a tried-and-true formula for success.
Remember that there will always be changes in the financial markets, economy, and inflation. If prices and wages didn't rise from year to year, that would signal an unhealthy economy. We have inflation in most years, and a reasonable amount is good for a healthy economy.
A final quick and dirty tip: Don't forget about the importance of maintaining emergency savings in the bank. Even though the interest you get is less than the inflation rate, you still need at least three to six months' worth of living expenses on hand no matter what's going on with the inflation rate.
What questions do you have about inflation and investing? Leave Laura a voicemail question, comment, or idea for a future topic by calling 302-364-0308. Be sure to follow her on Instagram and learn more about her books, online courses, and free newsletter at LauraDAdams.com.