Inflation is the topic of conversation in economic forums, political blogs and news media almost every single day. Almost every month, new monetary policies are made by the Federal Reserve. These policies affect many countries in different ways. One of the top priorities of the Fed is to make sure that inflation is under control. Before we proceed further, however, let us talk about what inflation is.
According to Wiki, inflation is a substantial and persistent increase in prices related to increase in money volume, which depreciates a currency’s overall value. To make things simple, inflation happens when one has too much money but it is not enough to get enough goods. This results in high process for certain products. Whether it is cell phones, education costs, toilet paper, apples, cars or any other thing, when there is an increase in inflation, the purchasing power of your money goes down.
This can be particularly problematic for people who have fixed incomes, such as senior citizens collecting social security or people who received a fixed pension.
How is Inflation Measured?
The consumer price index is arguably the most common measurement used to determine inflation. The CPI is essentially the basis for cost of living increases, government pensions and social security adjustments. Every month, the BLS, also known as the Bureau of Labor Statistics publishes its price survey and the results.
It weights and aggregates price data for several major categories, which includes hair care, tobacco, communication, education, recreation, medical care, transportation, apparel, housing, food and beverage etc. These services and goods are present in the consumer price index and are often used for measuring price changes with the passage of time.
Perceived Inflation vs. Real Inflation
Currently a bag of pistachios costs $22 at costs, when it used to cost only $15 just a year ago. Besides the hike in prices, companies are also offering their products in smaller packaging and quantities. Case in point, a bar of Haagen Dazs is half the size of the ones people got initially and the Fillet o Fish sandwiches at McDonalds today are small enough to pass for sliders.
While toilet paper prices may still be the same, the total amount of sheets inside a roll is not the same. There are lesser sheets now. Like most people, you may be under the impression that the prices have increased above the inflation rate published officially.
Then what accounts for the disconnect?
Sadly, the algorithm used for determining the consumer price index is not published. To make matters worse, it is not straightforward. There are several indexes referenced and published, especially the core consumer price index, which is followed by several financial analysts. This index excludes costs of energy and from the analysis.
Whenever the BLS determines the official rates, they tend to factor in the average prices for each category monitored by them. Therefore, if the cost of a TV goes down, it will offset the increasing prices of food. The problem with this is that you only buy TVs and cars every few years, while you purchase eggs and milk every week.
This is why the weighting will most likely not reflect household spending habits and you may be spending more money each month despite the inflation rate published being on the lower side.
What causes inflation?
Whenever there is an increase in the supply of money, inflation follows. This usually happens in a few ways. First off, banking systems are usually created on a concept known as fractional reserves. This concept lets banks receive savings, deposits money market accounts and whatnot. After that, banks can lend a higher amount of money than what they have.
Because this trade is not dollar for dollar, it results in the creation of more currency. This can be a favorable thing when the economy is improving and as the money is usually lent to consumers and business who can sustain the growth.
However, there is a downside as well, especially when the economy is in trouble. The problem mainly starts when the demand for money in the system is not enough. Whenever something like this happens, the currency’s value goes down, lowering everyone’s purchasing power. Another way money supply increases is through a simple stroke of the pen.
How does this happen? Well, the Federal Reserve simply grants the authority to print more money. After the financial crisis in 2008, the Federal Reserve stepped in and massive raised the monetary base for purchasing bonds and mortgages worth trillions of Dollars.
While this did help improve the economy for the short term, it eventually ended up increasing the national debt, something that was already burdened because of certain liabilities like medicate, deficit spending by the government and social security.
Getting Ready for Inflation
John Maynard Keynes, who happens to be a massively influential economist and the international monetary fund’s founder, reminded people about the how inflation impacts people by saying that if inflation continues over a long period, governments can end up confiscating a vital part of their citizen’s wealth.
It is also worth keeping in mind that inflation usually triggers higher interest rates because investors want higher returns for the risk they take. Other assets such as stock markets and real estate are also affected negatively and this leads to a downward spiral until there are necessary, painful changes for making the economy stable again.
That being said, there are certain steps people can take for preventing inflation from ruining their financial security. First off, it is important to stay well-informed and educated. Make sure you stay on top of everything that is happening to prepare for inflation emotionally as well as financially. After that, it would be best to form strong ties with people, including neighbors and family members to ensure you can help each other in times of trouble. Doing so will ensure that you have a solid network where you can share resources with each other and offer and receive psychological support.
When determining what you will most likely need for retirement, you must consider the impact of inflation and keep in mind that people usually live longer than they initially used to. Considering these two things can be quite helpful when forming a financial plan and could require a late retirement.
Finally, you must think about safeguarding yourself and your family from the horrors of inflation by diversifying your portfolio. Many experts suggest investing in silver and gold as they are known to perform quite well, especially when financial markets tend to falter. Many people even use these metals to hedge against their country’s poor economy. Coins can be a especially good option because they are easily portable and the entire world recognizes their value.
Inflation Hampers Workers' Ability to Plan for Retirement
When inflation is too high, investors should consider setting aside a massive chunk of their income for post-retirement. At the same time, however, the increasing cost of living could raise the risk of depleting your nest egg prematurely. Retirees who mostly depend on social security checks, however, do not have much to worry about, however, as they include annual cost of living adjustment, which essentially makes adjustments to inflation-time payments.
That said, retirees relying on social security must also consider other assets for other expenses like long term care.
Does Inflation Impact Retirement Withdrawals
Besides social security, thousands of retirees depend on portfolio withdrawals for funding a massive part of their retirement expenditure. Remember, inflation tends to be a massive factor that could impact the amount one can withdraw safely from their respective portfolio after retirement.
When it comes to retirement withdrawals, the four percent rule of thumb suggests that retires should adjust the withdrawal amount for each year’s inflation. However, this may not be possible if the inflation rates are too high.
Inflation Impacts Consumer Behavior and purchasing Power
Inflation can greatly complicate ones decision making process, especially when it comes to big ticket items. For instance, if someone is planning to replace their car in the near future, they often ponder if they should get the car while the prices are down right now or risk buying it later when it will most likely become expensive. Some people hold off on their purchase, hoping that the prices will remain the same or may even stabilize.
There are also those who may just postpone their plans because of the incredibly high fuel prices. With so much uncertainty, there is a great deal of stress involved as well and it comes people to make the wrong financial decisions.
