What is Inflation? & 6 Ways it Impacts Your Finances

High inflation has been in the news for most of 2022 and it’s something that’s a concern to everybody because it affects so many aspects of our lives. As of July of 2022, inflation was at a four-decade high.

At Addition Financial, we always want to educate our members about things that impact their finances. We’ve had a lot of members asking this question and related questions:

“What is inflation and how will it affect my finances?”

With that in mind, here’s what you need to know about inflation and why it occurs, as well as six ways that high inflation can impact your finances.

What is the Definition of Inflation?

Inflation is an economic term referring to an increase in the price of a so-called “basket” of consumer goods and services called the Consumer Price Index, or CPI. You’ve probably heard people refer to the cost of living and that’s a term that’s related to inflation. Consumer price inflation is normal and is not empirically bad. 

In a typical year of economic growth, the Federal Reserve assumes that there will be inflation of about 2%. Any inflation rate between 1.5% and 4% is considered to be in the normal range. A review of inflation by year reveals that there have been only a few years when inflation has been over 4% since the early 1980s, when inflation was at double digits. 

There are two related terms you should know. Deflation describes a period when consumer prices decrease instead of increasing. While the thought of lower prices might seem appealing, deflation is not always good news. The most significant period of deflation in US history happened after the stock market crash of 1929.

The other term you should know is stagflation, which occurs when there is high inflation and the economy is growing at a sluggish rate, usually less than 1%. Stagflation can be a precursor of recession.

How Are Money Supply and Inflation Related?

There are multiple things that can cause high inflation. Reviewing the two most common will illustrate the connection between the available supply of money and the rate of inflation.

The first type of inflation is called Demand-Pull Inflation. It occurs when there is a lot of money in the economy which leads to high demand for consumer goods and services. Inflation rises when the consumer demand for products exceeds the economy’s ability to produce them. This type of inflation leads manufacturers to charge more for products.

The demand-pull phenomenon is part of the explanation for why we have high inflation in 2022. The COVID-19 pandemic stimulus payments put money into the economy. While people were conservative with their spending at first, that changed in 2021 and high demand has driven prices up.

The second type of inflation is called Cost-Push Inflation and it’s related to an increase in the cost of production of goods. When increases in production costs occur, manufacturers increase their prices to maintain their profit margins. An example of this is when speculation in oil prices increases and the price level of gas goes up.

The high inflation in 2022 has been driven by both of these phenomena. The influx of money into the economy has created high demand for consumer goods and services while increased production costs and supply chain issues have also played a role in reducing the supply of consumer goods.

6 Ways Inflation Impacts Your Finances

Now that you understand what inflation is and what causes it, let’s look at some of the specific ways that high inflation impacts your finances.

#1: Inflation Reduces the Value of Your Savings

Saving money is a priority for many of our members, and one of the most important ways that high inflation can affect members’ personal finances is by reducing the purchasing power of their savings. To get an idea of how significant the effect can be, you can use the rule of 72.

The rule of 72 says that you can take 72 and divide it by the rate of inflation to learn how many years it will take for inflation to halve the value of your savings. At the rate of inflation in July of 2022, which is 8.5%, your money would lose half its value in about eight and a half years. 

The thing to keep in mind is that it’s unlikely that the US will experience that long a period of high inflation. That said, people who are already retired or close to retirement age will need to think about how high inflation will impact their savings and may need to rebudget to ensure that they don’t run out of money. The same is true if you have a college savings or emergency savings account or you’re saving for a down payment on a house.

#2: Inflation Can Impact the Value of Your Investments

Anybody who has money invested for retirement or another purpose, such as paying for college, should know that high inflation may impact the value of their investments – although not always in a negative way.

Stocks and bonds are impacted differently by inflation. Regular bonds and CDs may be hurt by inflation since you’ll earn the same interest payment each year. As the purchasing power of money decreases, so does the value of your earnings on the investment.

The impact of high inflation on stocks is more of a mixed bag. High demand may mean that companies are selling more than usual and that can increase the price of shares and boost the value of your investments. On the flip side, companies may be paying more for raw materials, supplies and wages, which can hurt the value of shares.

Certain bonds and annuities are indexed for inflation, meaning that they earn more when inflation is high and less when it is low. These investments can protect your money, as can buying certain commodities, including gold, whose value increases when inflation is high.

#3: Inflation Decreases the Purchasing Power of Money

We already talked about the impact of inflation on your savings, but you should know that it also means that the money you earn is worth less and you’ll be able to buy less with it. The chances are good that you’ve already noticed that a trip to the gas station or the grocery store comes with a high price tag as food prices and price levels in general have increased.

Whatever salary or wage you earn, your paycheck has less purchasing power in periods of high inflation than it does when inflation is normal. According to the Bureau of Labor Statistics, the price of a gallon of milk increased from $3.56 in June of 2021 to $4.15 in June of 2022. That’s an increase of 16.57% in one year. Put another way, a dollar buys 16.57% less milk in June of 2022 than it did in June of 2021.

#4: Inflation May Increase Home Equity

One of the potentially positive effects of inflation is that it increases home prices and at the same time, increases home equity. According to Redfin, home prices increased by 11% between June of 2021 and June of 2022. That’s a rate higher than the rate of inflation.

According to a CNBC report, homeowners have gained a massive $1.2 trillion in home equity thanks to high inflation in 2022. With higher equity and higher prices, the potential exists for homeowners to sell their houses and walk away with a much higher profit than would have been possible with lower prices and lower equity.

#5: Inflation Leads to Increases in Interest Rates

While there are exceptions, interest rates and inflation tend to increase in concert with one another. It’s common for the Federal Reserve to increase interest rates through monetary policy when inflation exceeds expectations to try to keep inflation under control.

The explanation of interest rate increases is that higher interest rates may act as a brake, slowing the economy enough to lower prices. On July 27 of this year, the Federal Reserve announced its fourth interest rate increase of 2022. It remains to be seen how the latest increase will impact inflation.

High interest rates impact consumers in a variety of ways. They make it more expensive to get a mortgage and may price some buyers out of the housing market. They can also make it difficult for homeowners to find prospective buyers for their homes.

#6: Inflation Lowers Debt Service Costs

Another effect of inflation on homeowners is that it decreases debt service costs for people who have fixed rate loans or mortgages. That’s because the dollar amount you pay each month is fixed. If you have a $1,500 mortgage payment, paying it at a time of high inflation means that you’re putting less of your spending power into paying down your loan balance than you would in a time of low inflation.

Said another way, many existing mortgages were issued at a fixed rate far lower than the rate of inflation. When that happens, the effective rate of those mortgages is negative because the payments reduce the borrower’s debt by more than the payment itself is worth.

free inflation infographic

The impact of rising inflation on personal finance is undeniable, but as you can see, not all effects are negative. Understanding the six ways that inflation can impact your personal finances can help you make informed decisions about everything from grocery shopping to retirement savings.

Do you need assistance choosing the right investments? Addition Financial is here to help! Click here to learn about our MEMBERS Financial Services program and schedule a meeting with one of our Financial Professionals.

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