Understand what causes inflation and how to protect your assets against it.
Has inflation been on your mind? In this episode I’ll discuss what causes inflation and tell you about investment vehicles to help protect your nest egg.
What Is Inflation?
Inflation is a rise in the general level of prices of goods and services over time. This is shown by the fact that 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!
The value of a dollar can only be measured by its purchasing power. As inflation causes prices to rise, every dollar buys a smaller percentage of a good or service. If the inflation rate is 4%, then a $2 loaf of bread will cost $2.08 in a year. After inflation, our money simply doesn’t buy the same goods or services that it did beforehand. This is why many people fear inflation and think of it as an evil force that must be tamed.
What Causes Inflation?
So, what causes inflation? Well, the most accepted idea about inflation is that it results from increases in the money supply of an economy.
To understand this monetarist view, imagine an 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 in the economy available to buy the same amount of bread. This will drive up the prices that consumers are willing to pay.
How Inflation is Measured
There are many measures of inflation. But the most well-known is the Consumer Price Index or CPI. The CPI reveals changes in retail prices of a basket of consumer goods such as food, clothing, and cars. The index compares the value of the same basket each year to calculate the level of inflation for that period. It's published monthly by the Bureau of Labor Statistics.
Here's a handy inflation calculator that allows you to adjust any amount of money for inflation, according to the CPI, from 1800 to the present.
Nominal vs. Real Interest Rates
The real worth of your assets is not their absolute dollar amount, but what could be bought with those dollars. If your investments are making returns at or below the inflation rate, they're losing value.
So it's important to understand the difference between nominal interest rates and real interest rates. A nominal interest rate is not adjusted for inflation, and a real interest rate has been adjusted for inflation. So the real interest rate is the nominal rate minus inflation.
For example if you earn 5% interest per year on money in a CD and inflation is 4% per year, then the real interest rate you are receiving is 1% (that's 5% - 4%). The real value of your investment will only increase by 1%, when the purchasing power of the money is taken into consideration.
Investments that Offset Inflation
So, how can assets be protected from inflation? Inflation-indexed securities guarantee a return higher than the rate of inflation if held to maturity. These real returns offer protection against inflation, but provide low returns on investment.
The following are 5 different types of inflation-protected securities:
1. Treasury Inflation-Protected Securities (TIPS) are backed by the federal government. They pay interest on a principal amount that's adjusted for inflation as measured by the CPI.
Here's a tip about TIPS: to avoid having to pay the income tax that results from the increased principal value, hold these investments in a tax-deferred account such as an IRA.
2. Municipal Inflation-Linked Securities are issued by various government entities. They pay interest based on the CPI. They're similar to municipal bonds in that they are exempt from federal taxes and from most state and local taxes.
3. Corporate Inflation-Linked Securities are issued by companies. They carry more risk and therefore pay higher returns. The yields adjust monthly for changes in the inflation rate.
4. Inflation-Linked Certificates of Deposit are insured by the Federal Deposit Insurance Corporation (FDIC). The interest rates change annually based on inflation changes.
5. Inflation-Linked Savings Bonds (I Bonds) are backed by the federal government. They grow with inflation-indexed earnings for up to 30 years. Federal income tax is deferred until the bonds mature or you sell them and they're exempt from state and local income taxes.
More financial institutions are marketing inflation-protected securities to investors who believe inflation will continue to rise. The investments can take the form of individual securities or mutual funds.
Before I go, here's one final tip to battle inflation. When possible, negotiate employment contracts that include an automatic annual increase that matches the prior year's inflation rate.
Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
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This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice. Be sure to consult a tax or financial advisor before making important financial decisions.
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