As the United States slowly recovers from the 2020 pandemic, the most talked about issue isn’t even COVID anymore; instead our new problem is inflation. We as a society have moved on from one major national issue to another. However, where COVID was something you could visibly see from the immediate effect it had on your body, inflation is something that slowly takes over your life and before you realize what’s happening your paycheck, monthly budget, credit cards, car payment, and financial investments all have been impacted in some way.
What is Inflation
In simple terms, inflation is the gradual rise in the prices of goods and services that we as a society purchase to meet our basic needs. Inflation is continuously monitored and measured by our government to ensure that our economy is running healthy and inflation does not run out of control. The Consumer Price Index (CPI) is the tool used to measure the average change in price over time.
Now that we understand that inflation means the overall rise of cost of living, we can try to understand what can cause inflation to actually rise. Inflation is usually caused by two scenarios, which are easy to understand:
Cost Inflation: This inflation is caused by the rise in cost of producers or manufacturers attempting to do business. The rise in prices of labor, material, and transportation for the manufacturer results in the manufacturer increasing the price of their products, so the manufacturer can cover their costs.
Demand Inflation: This inflation is caused by the consumers seeking high demand of an item. The producer or manufacturer of that item recognizes that consumers are willing to pay more money for that item and purposely charges the consumer higher prices.
Results of High Levels of Inflation
While inflation is constantly being monitored by the CPI, if the level of inflation is too high there can be some serious negative results. As a result of high inflation, the central bank of the United States, known as the Federal Reserve System or simply the Fed, will start to take measured action to curb the rising prices. The key weapon that the Fed has against inflation is raising the interest rates that banks use to borrow money. When banks are forced to use higher rates to borrow money for themselves, then they also charge higher rates to their borrowers as well. You’ll see that banks will charge you more to take out loans so they can cover their costs. In addition to that, other costs go up as well, such as: credit cards, mortgage loans, and car loans. You can see there is a domino affect when the Fed decides to raise interest rates due to inflation.
How Does Inflation Impact Your Investment?
The most obvious and immediate impact is your money slowly declines, which is officially labeled as your purchasing power goes down. Basically, you will be spending more and buying fewer goods with your money. As we discussed before, when the Fed raises rates to control inflation, your credit cards, mortgage loans and car loans go up. In addition, purchasing groceries, car fuel, clothes, and paying rent will be impacted too, because everything has gone up and it will trickle down to those items as well. Your overall cost of living has just gone up and we have not even discussed your investments yet.
Most individuals first reaction to their investments is to stop putting money into their investment accounts because they need more money to survive for their basic needs. Some go to more extremes and take money out of their investment accounts and use that extra cash just to get by. Instead, I recommend cutting back spending; instead of taking out money from your investment accounts, try to cut expenses from your everyday lifestyle instead. Of course, this is easier said then done but strict discipline is required to ensure that you meet your investment goals; so the better decision is to weather the inflation storm by cutting down on your spending habits and work on getting a promotion at your job or get another job.
The most important item to understand during inflation is that your money is losing value by rising costs, which means you should not just keep savings in a bank. Instead, put your money where the rate of return can keep up with the rate of inflation. To protect your purchasing power and investment returns, diversification is very important. Here are ways to protect your money from inflation and Fed rate hikes:
Stock Market: Although stocks might immediately react negatively to the news of the Fed raising rates to curb inflation, if you stick with it in the long run your investments should be fine. Being a long-term investor is key to winning in the stock market.
Bonds: When the Fed raises rates, the current existing bonds might lose value but new bonds will come out to offer better interest rates. Treasury Inflation Protected Security (TIPS), which are treasury bonds which value rises as inflation rises, might be a good safe option.
Deposit Accounts: With raised interest rates, banks will also increase the amount you earn from certificates of deposit (CD) and money market accounts. This would be a good time to take advantage of those rewards from banks.
Mutual Funds: This is a good safe option to have since mutual funds give a good diversified option. However, make sure you check the fees or commissions that come with that because it eats away your investments.
Inflation has certain behaviors that will decrease your purchasing power. It is your responsibility as an investor to protect your money and ensure that your investment returns are at least the same rate as inflation. In addition, make sure that you are constantly receiving or working towards cost of living increases by achieving promotions or raises. Even if it requires you to look for another job, it is worth keeping up with the cost of living.
