Six things you need to know about inflation
How inflation can affect your finances
The good news: If you organize your spending and investments wisely, price increases are unlikely to have a significant adverse impact on your finances (or financial well-being).
Over the long-term, however, inflation could eat away at the value of your money. Here are six things you should know about inflation:
1. How is inflation measured?
Inflation refers to the increase in the prices of goods and services over time. While there are many ways to measure inflation, the most relevant measure for most people is the Consumer Price Index (CPI) used by the U.S. Bureau of Labor Statistics (BLS). Every month, the BLS surveys 23,000 businesses to log price fluctuations in goods and services — everything from retail goods and food and gas to healthcare, housing and education.
2. What causes inflation?
Inflation has two main causes:
Increased demand. When the demand for goods and services increases, suppliers often respond by raising prices. Compelling marketing, new technology, a growing economy, government policy and the expectation of future inflation can all increase demand or raise prices.
Reduced supply. A shortage in supply, coupled with steady demand, can also lead to inflation. This type of inflation sometimes occurs when wages rise. It can also be caused by government regulation and taxation and/or a decline in currency exchange rates.
3. What are the effects of inflation?
When inflation happens, the purchasing power of the dollar goes down. In other words, your money becomes less valuable.
Inflation impacts different groups in different ways. It can be especially harmful for:
- Those with lower incomes. Lower-income populations spend a high proportion of their income on basic necessities, so they don’t have a lot they can cut back on.
- Businesses working on fixed contracts. These businesses may suffer big losses from inflation because they can't pass along higher prices to their customers.
- Retirees. Many retirees rely on savings and fixed sources of income such as pensions. Inflation causes their money to be worth less.
Not everyone suffers from high inflation rates, though. It can actually help some people and organizations, including:
- Those who owe money. Inflation essentially makes money cheaper to pay back — as long as your debt doesn’t continue to increase.
- Homeowners. Costs generally don’t rise as much for those who own their own home.
- Governments. Governments tend not to mind some inflation because it makes debt look cheaper.
4. How does inflation affect investment returns?
Most investors want to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation. For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (−1%) when adjusted for inflation.
If investors do not protect their portfolios, inflation can be harmful. Many investors buy fixed-income securities (bonds) because they want a stable income stream, which comes in the form of interest payments. However, because the rate of interest, or coupon, on most fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises. In addition, inflation typically leads to rising interest rates, which erodes the value of the principal on fixed-income securities.
Unlike bonds, some assets increase in price as inflation accelerates. Price increases can sometimes offset the negative impact of inflation. This outcome is particularly true for:
- Stocks. Stocks have often been a good investment relative to inflation over the very long-term: Companies can raise prices for their products when their costs increase in an inflationary environment. Higher prices may translate into higher earnings.
- Inflation-linked bonds. These bonds, which are issued by many governments, are explicitly tied to changes in inflation. For example, Treasury inflation-protected securities (TIPS) are issued by the U.S. government and pay a nominal rate of interest plus the annual rate of inflation as measured by the CPI.
- Floating-rate notes. These assets offer coupons that rise and fall with key interest rates. The interest rate on a floating-rate security is reset periodically to reflect changes in a base interest rate index, such as the London Interbank Offered Rate (LIBOR). Because of this link, floating-rate notes have been positively correlated with inflation, meaning their returns have tended to rise when inflation increases and fall when it declines.
5. How concerned should I be about recent increases in inflation?
Consumer prices in the U.S. continue to rise in 2022, sparking the largest annual increase in inflation that we’ve witnessed in 40 years. In fact, from January 2021 to January 2022, the CPI spiked 7.5%, the most extreme bump on a year-on-year basis since February 1982. Costs for housing, food and electricity have all skyrocketed, creating uncertainty and anxiety for Americans. *
The recent spike in prices has been driven by supply chain disruptions and pent-up demand for goods following the reopening of the economy in 2021. In addition, the trillions of dollars from federal pandemic relief programs distributed over the past two years have stoked demand for Americans to spend more.
* Reuters.com, “U.S. consumer prices post largest annual gain in 40 years as inflation becomes widespread,” February 2022.
6. What will happen next with inflation?
Policymakers are watching inflation numbers closely. Some reports indicate monthly inflation could ease as supply bottlenecks improve and COVID cases begin to trend downward.
It’s important to remember that sharp increases in inflation are typically temporary, but it’s hard to know when rates will normalize. The Biden administration, Congress and the Federal Reserve are expected to continue to support the economy with policy measures aimed at keeping inflation in check.
All statistics above are from the U.S. Bureau of Labor Statistics unless otherwise noted. The research, views and opinions are intended to be educational and are not tax, legal, accounting or investment advice.
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